Financial Instruments

This compiled Standard applies to annual reporting periods beginning on or after 1 January 2018.  Early application is permitted.  It incorporates relevant amendments made up to and including 17 December 2014.

Prepared on 20 March 2015 by the staff of the Australian Accounting Standards Board.

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COPYRIGHT

© 2015 Commonwealth of Australia

This compiled AASB Standard contains IFRS Foundation copyright material.  Reproduction within Australia in unaltered form (retaining this notice) is permitted for personal and non-commercial use subject to the inclusion of an acknowledgment of the source.  Requests and enquiries concerning reproduction and rights for commercial purposes within Australia should be addressed to The Director of Finance and Administration, Australian Accounting Standards Board, PO Box 204, Collins Street West, Victoria 8007.

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CONTENTS

COMPILATION DETAILS

Comparison with ifrs 9

Accounting Standard

AASB 9 Financial Instruments

Paragraphs

Objective and application 1.1 – Aus1.8

Scope 2.1

Recognition and derecognition

Initial recognition 3.1.1

Regular way purchase or sale of financial assets 3.1.2

Derecognition of financial assets 3.2.1 – 3.2.9

Transfers that qualify for derecognition 3.2.10 – 3.2.14

Transfers that do not qualify for derecognition 3.2.15

Continuing involvement in transferred assets 3.2.16 – 3.2.21

All transfers 3.2.22 – 3.2.23

Derecognition of financial liabilities 3.3.1 – 3.3.4

Classification 

Classification of financial assets 4.1.1 – 4.1.4

Option to designate a financial asset at fair value through profit or loss 4.1.5 – 4.1.6

Classification of financial liabilities 4.2.1

Option to designate a financial liability at fair value through profit or loss 4.2.2 – 4.2.3

Embedded derivatives 4.3.1

Hybrid contracts with financial asset hosts 4.3.2

Other hybrid contracts 4.3.3 – 4.3.7

Reclassification 4.4.1 – 4.4.3

Measurement 

Initial measurement 5.1.1 – 5.1.3

Subsequent measurement of financial assets 5.2.1 – 5.2.3

Subsequent measurement of financial liabilities 5.3.1 – 5.3.2

Reclassification of financial assets 5.6.1 – 5.6.3

Gains and losses 5.7.1 – 5.7.4

Investments in equity instruments 5.7.5 – 5.7.6

Liabilities designated as at fair value through profit or loss 5.7.7 – 5.7.9

Hedge accounting

Objective and scope of hedge accounting 6.1.1 – 6.1.3

Hedging instruments

Qualifying instruments 6.2.1 – 6.2.3

Designation of hedging instruments 6.2.4 – 6.2.6

Hedged items

Qualifying items 6.3.1 – 6.3.6

Designation of hedged items 6.3.7

Qualifying criteria for hedge accounting 6.4.1

Accounting for qualifying hedging relationships 6.5.1 – 6.5.7

Fair value hedges 6.5.8 – 6.5.10

Cash flow hedges 6.5.11 – 6.5.12

Hedges of a net investment in a foreign operation 6.5.13 – 6.5.14

Accounting for the time value of options 6.5.15

Accounting for the forward element of forward contracts and foreign currency basis spreads of financial instruments              6.5.16

Hedges of a group of items

Eligibility of a group of items as the hedged item 6.6.1

Designation of a component of a nominal amount 6.6.2 – 6.6.3

Presentation 6.6.4 – 6.6.5

Nil net positions 6.6.6

Option to designate a credit exposure as measured at fair value through profit or loss

Eligibility of credit exposures for designation at fair value through profit or loss 6.7.1

Accounting for credit exposures designated at fair value through profit or loss 6.7.2 – 6.7.4

Effective date and transition

Effective date 7.1.2 – 7.1.4

Transition 7.2.1 – 7.2.14

Entities that have applied AASB 9 (2009) or AASB 9 (2010) early 7.2.15

Transition for hedge accounting (Chapter 6) 7.2.16 – 7.2.21

Appendices:

A.  Defined Terms Page 30

B.  Application Guidance Page 32

DELETED IFRS 9 TEXT Page 73

IMPLEMENTATION GUIDANCE ON IFRS 9
(available on the AASB website)

BASIS FOR CONCLUSIONS ON IFRS 9
(available on the AASB website)

Australian Accounting Standard AASB 9 Financial Instruments (as amended) is set out in paragraphs 1.1 – 7.2.21 and Appendices A and B.  All the paragraphs have equal authority.  Paragraphs in bold type state the main principles.  AASB 9 is to be read in the context of other Australian Accounting Standards, including AASB 1048 Interpretation of Standards, which identifies the Australian Accounting Interpretations.  In the absence of explicit guidance, AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors provides a basis for selecting and applying accounting policies.

compilation details

Accounting Standard AASB 9 Financial Instruments as amended

This compiled Standard applies to annual reporting periods beginning on or after 1 January 2018.  It takes into account amendments up to and including 17 December 2014 and was prepared on 20 March 2015 by the staff of the Australian Accounting Standards Board (AASB).

This compilation is not a separate Accounting Standard made by the AASB.  Instead, it is a representation of AASB 9 (December 2010) as amended by other Accounting Standards, which are listed in the Table below.

Table of Standards

(a) AASB 9 applies to annual reporting periods beginning on or after 1 January 2018 (instead of 1 January 2017) as a result of amendments made by Part E of AASB 2014-1 Amendments to Australian Accounting Standards.

 Entities may elect to apply this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9.

(b) AASB 2011-7 has been amended by AASB 2012-6 (made 10 September 2012) and AASB 2012-10 (made 18 December 2012).

 Entities may elect to apply the amendments to AASB 9 in this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9, provided that AASB 10 Consolidated Financial Statements and associated Standards are also applied.

(c) AASB 2011-8 has been amended by AASB 2011-10 (made 5 September 2011) and AASB 2012-6 (made 10 September 2012).

 Entities may elect to apply the amendments to AASB 9 in this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9, provided that AASB 13 Fair Value Measurement is also applied to such periods.

(d) Entities may elect to apply the amendments to AASB 9 in this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9.

(e) Early application of Part B of this Standard is not permitted.

(f) Entities may elect to apply Part C of this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9.

(g) Entities may elect to apply the amendments to AASB 9 in Part A of this Standard to annual reporting periods ending on or after 31 December 2009 that begin before 1 July 2014.

(h) Entities may elect to apply Part E of this Standard as set out in paragraphs Aus1.3 and Aus1.4 of AASB 9.

(i) Entities may elect to apply the amendments to AASB 9 (2010) in this Standard only as set out in paragraph Aus1.4 of AASB 9 (2010), provided that AASB 15 Revenue from Contracts with Customers is also applied to such periods.

(j) Entities may elect to apply the amendments to AASB 9 (2010) in this Standard if, and only if, the entity’s date of initial application is before 1 February 2015.

Table of Amendments

cOMPARISON WITH IFRS 9

AASB 9 and IFRS 9

AASB 9 Financial Instruments as amended incorporates IFRS 9 Financial Instruments as issued and amended by the International Accounting Standards Board (IASB).  Paragraphs that have been added to this Standard (and do not appear in the text of IFRS 9) are identified with the prefix “Aus”, followed by the number of the preceding IASB paragraph and decimal numbering.  Paragraphs that apply only to not-for-profit entities begin by identifying their limited applicability.

Compliance with IFRS 9

Entities that comply with AASB 9 as amended will simultaneously be in compliance with IFRS 9 as amended.

aCCOUNTING STANDARD AASB 9

Financial Instruments

Chapter 1  Objective and application

1.1 The objective of this Standard is to establish principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows. 

Aus1.2 This Standard applies to:

(a) each entity that is required to prepare financial reports in accordance with Part 2M.3 of the Corporations Act and that is a reporting entity;

(b) general purpose financial statements of each other reporting entity; and

(c) financial statements that are, or are held out to be, general purpose financial statements.

Aus1.3 This Standard applies to annual reporting periods beginning on or after 1 January 2018 and may be applied early only as set out in paragraph Aus1.4.  However, AASB 9 (December 2014) supersedes this Standard.  An entity shall apply AASB 9 (December 2014) for annual reporting periods beginning on or after 1 January 2018.

Aus1.4 For annual reporting periods beginning before 1 January 2018, an entity may apply this Standard from:

(a) any date between the issue of this Standard and 31 December 2010, for entities initially applying this Standard before 1 January 2011; or

(b) the beginning of the first reporting period in which the entity adopts this Standard, for entities initially applying this Standard on or after 1 January 2011;

if, and only if, the entity’s date of initial application (as described in paragraph 7.2.2) is before 1 February 2015.  When an entity elects to apply this Standard, it must apply all of the requirements in this Standard at the same time (but see also paragraphs 7.1.2, 7.2.15 and 7.2.16).  If an entity applies this Standard, it shall disclose that fact and at the same time apply the amendments in AASB 2010-7 Amendments to Australian Accounting Standards arising from AASB 9 (December 2010) (as amended) and the amendments in Part E of AASB 2014-1 Amendments to Australian Accounting Standards.

Aus1.5 [Deleted by the AASB]

Aus1.6 [Deleted by the AASB]

Aus1.7 When applied or operative, this Standard supersedes AASB 9 issued in December 2009 (as amended).  However, for annual reporting periods beginning before 1 January 2018, an entity may elect to apply AASB 9 issued in December 2009 (as amended) or this Standard as amended to September 2012, instead of applying this Standard (as amended to December 2014) if, and only if, the entity’s date of initial application is before 1 February 2015.

Aus1.8 When applied or operative, this Standard supersedes Interpretation 9 Reassessment of Embedded Derivatives, as identified in AASB 1048 Interpretation of Standards.  The requirements added to AASB 9 in December 2010 incorporate the requirements previously set out in paragraphs 5 and 7 of Interpretation 9.  As a consequential amendment, AASB 1 First-time Adoption of Australian Accounting Standards incorporates the requirements previously set out in paragraph 8 of Interpretation 9.

Chapter 2  Scope

2.1 An entity shall apply this Standard to all items within the scope of AASB 139 Financial Instruments: Recognition and Measurement.

Chapter 3  Recognition and derecognition

3.1 Initial recognition

3.1.1 An entity shall recognise a financial asset or a financial liability in its statement of financial position when, and only when, the entity becomes party to the contractual provisions of the instrument (see paragraphs B3.1.1 and B3.1.2).  When an entity first recognises a financial asset, it shall classify it in accordance with paragraphs 4.1.1-4.1.5 and measure it in accordance with paragraphs 5.1.1-5.1.3.  When an entity first recognises a financial liability, it shall classify it in accordance with paragraphs 4.2.1 and 4.2.2 and measure it in accordance with paragraph 5.1.1.

Regular way purchase or sale of financial assets

3.1.2 A regular way purchase or sale of financial assets shall be recognised and derecognised, as applicable, using trade date accounting or settlement date accounting (see paragraphs B3.1.3-B3.1.6).

3.2 Derecognition of financial assets

3.2.1 In consolidated financial statements, paragraphs 3.2.2-3.2.9, B3.1.1, B3.1.2 and B3.2.1-B3.2.17 are applied at a consolidated level.  Hence, an entity first consolidates all subsidiaries in accordance with AASB 10 Consolidated Financial Statements and then applies those paragraphs to the resulting group.

3.2.2 Before evaluating whether, and to what extent, derecognition is appropriate under paragraphs 3.2.3-3.2.9, an entity determines whether those paragraphs should be applied to a part of a financial asset (or a part of a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety, as follows. 

(a) Paragraphs 3.2.3-3.2.9 are applied to a part of a financial asset (or a part of a group of similar financial assets) if, and only if, the part being considered for derecognition meets one of the following three conditions. 

(i) The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets).  For example, when an entity enters into an interest rate strip whereby the counterparty obtains the right to the interest cash flows, but not the principal cash flows from a debt instrument, paragraphs 3.2.3-3.2.9 are applied to the interest cash flows. 

(ii) The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets).  For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of all cash flows of a debt instrument, paragraphs 3.2.3-3.2.9 are applied to 90 per cent of those cash flows.  If there is more than one counterparty, each counterparty is not required to have a proportionate share of the cash flows provided that the transferring entity has a fully proportionate share.

(iii) The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets).  For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of interest cash flows from a financial asset, paragraphs 3.2.3-3.2.9 are applied to 90 per cent of those interest cash flows.  If there is more than one counterparty, each counterparty is not required to have a proportionate share of the specifically identified cash flows provided that the transferring entity has a fully proportionate share.

(b) In all other cases, paragraphs 3.2.3-3.2.9 are applied to the financial asset in its entirety (or to the group of similar financial assets in their entirety).  For example, when an entity transfers (i)  the rights to the first or the last 90 per cent of cash collections from a financial asset (or a group of financial assets), or (ii) the rights to 90 per cent of the cash flows from a group of receivables, but provides a guarantee to compensate the buyer for any credit losses up to 8 per cent of the principal amount of the receivables, paragraphs 3.2.3-3.2.9 are applied to the financial asset (or a group of similar financial assets) in its entirety. 

In paragraphs 3.2.3-3.2.12, the term ‘financial asset’ refers to either a part of a financial asset (or a part of a group of similar financial assets) as identified in (a) above or, otherwise, a financial asset (or a group of similar financial assets) in its entirety. 

3.2.3 An entity shall derecognise a financial asset when, and only when:

(a) the contractual rights to the cash flows from the financial asset expire, or

(b) it transfers the financial asset as set out in paragraphs 3.2.4 and 3.2.5 and the transfer qualifies for derecognition in accordance with paragraph 3.2.6.

(See paragraph 3.1.2 for regular way sales of financial assets.)

3.2.4 An entity transfers a financial asset if, and only if, it either:

(a) transfers the contractual rights to receive the cash flows of the financial asset; or

(b) retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients in an arrangement that meets the conditions in paragraph 3.2.5.

3.2.5 When an entity retains the contractual rights to receive the cash flows of a financial asset (the ‘original asset’), but assumes a contractual obligation to pay those cash flows to one or more entities (the ‘eventual recipients’), the entity treats the transaction as a transfer of a financial asset if, and only if, all of the following three conditions are met. 

(a) The entity has no obligation to pay amounts to the eventual recipients unless it collects equivalent amounts from the original asset.  Short-term advances by the entity with the right of full recovery of the amount lent plus accrued interest at market rates do not violate this condition.

(b) The entity is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows.

(c) The entity has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay.  In addition, the entity is not entitled to reinvest such cash flows, except for investments in cash or cash equivalents (as defined in AASB 107 Statement of Cash Flows) during the short settlement period from the collection date to the date of required remittance to the eventual recipients, and interest earned on such investments is passed to the eventual recipients.

3.2.6 When an entity transfers a financial asset (see paragraph 3.2.4), it shall evaluate the extent to which it retains the risks and rewards of ownership of the financial asset.  In this case:

(a) if the entity transfers substantially all the risks and rewards of ownership of the financial asset, the entity shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

(b) if the entity retains substantially all the risks and rewards of ownership of the financial asset, the entity shall continue to recognise the financial asset.

(c) if the entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, the entity shall determine whether it has retained control of the financial asset.  In this case:

(i) if the entity has not retained control, it shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

(ii) if the entity has retained control, it shall continue to recognise the financial asset to the extent of its continuing involvement in the financial asset (see paragraph 3.2.16). 

3.2.7 The transfer of risks and rewards (see paragraph 3.2.6) is evaluated by comparing the entity’s exposure, before and after the transfer, with the variability in the amounts and timing of the net cash flows of the transferred asset.  An entity has retained substantially all the risks and rewards of ownership of a financial asset if its exposure to the variability in the present value of the future net cash flows from the financial asset does not change significantly as a result of the transfer (eg because the entity has sold a financial asset subject to an agreement to buy it back at a fixed price or the sale price plus a lender’s return).  An entity has transferred substantially all the risks and rewards of ownership of a financial asset if its exposure to such variability is no longer significant in relation to the total variability in the present value of the future net cash flows associated with the financial asset (eg because the entity has sold a financial asset subject only to an option to buy it back at its fair value at the time of repurchase or has transferred a fully proportionate share of the cash flows from a larger financial asset in an arrangement, such as a loan sub-participation, that meets the conditions in paragraph 3.2.5). 

3.2.8 Often it will be obvious whether the entity has transferred or retained substantially all risks and rewards of ownership and there will be no need to perform any computations.  In other cases, it will be necessary to compute and compare the entity’s exposure to the variability in the present value of the future net cash flows before and after the transfer.  The computation and comparison are made using as the discount rate an appropriate current market interest rate.  All reasonably possible variability in net cash flows is considered, with greater weight being given to those outcomes that are more likely to occur.

3.2.9 Whether the entity has retained control (see paragraph 3.2.6(c)) of the transferred asset depends on the transferee’s ability to sell the asset.  If the transferee has the practical ability to sell the asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without needing to impose additional restrictions on the transfer, the entity has not retained control.  In all other cases, the entity has retained control.

Transfers that qualify for derecognition

3.2.10 If an entity transfers a financial asset in a transfer that qualifies for derecognition in its entirety and retains the right to service the financial asset for a fee, it shall recognise either a servicing asset or a servicing liability for that servicing contract.  If the fee to be received is not expected to compensate the entity adequately for performing the servicing, a servicing liability for the servicing obligation shall be recognised at its fair value.  If the fee to be received is expected to be more than adequate compensation for the servicing, a servicing asset shall be recognised for the servicing right at an amount determined on the basis of an allocation of the carrying amount of the larger financial asset in accordance with paragraph 3.2.13.

3.2.11 If, as a result of a transfer, a financial asset is derecognised in its entirety but the transfer results in the entity obtaining a new financial asset or assuming a new financial liability, or a servicing liability, the entity shall recognise the new financial asset, financial liability or servicing liability at fair value.

3.2.12 On derecognition of a financial asset in its entirety, the difference between:

(a) the carrying amount (measured at the date of derecognition); and

(b) the consideration received (including any new asset obtained less any new liability assumed);

shall be recognised in profit or loss.

3.2.13 If the transferred asset is part of a larger financial asset (eg when an entity transfers interest cash flows that are part of a debt instrument, see paragraph 3.2.2(a)) and the part transferred qualifies for derecognition in its entirety, the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognised and the part that is derecognised, on the basis of the relative fair values of those parts on the date of the transfer.  For this purpose, a retained servicing asset shall be treated as a part that continues to be recognised.  The difference between:

(a) the carrying amount (measured at the date of derecognition) allocated to the part derecognised; and

(b) the consideration received for the part derecognised (including any new asset obtained less any new liability assumed);

shall be recognised in profit or loss.

3.2.14 When an entity allocates the previous carrying amount of a larger financial asset between the part that continues to be recognised and the part that is derecognised, the fair value of the part that continues to be recognised needs to be measured.  When the entity has a history of selling parts similar to the part that continues to be recognised or other market transactions exist for such parts, recent prices of actual transactions provide the best estimate of its fair value.  When there are no price quotes or recent market transactions to support the fair value of the part that continues to be recognised, the best estimate of the fair value is the difference between the fair value of the larger financial asset as a whole and the consideration received from the transferee for the part that is derecognised.

Transfers that do not qualify for derecognition

3.2.15 If a transfer does not result in derecognition because the entity has retained substantially all the risks and rewards of ownership of the transferred asset, the entity shall continue to recognise the transferred asset in its entirety and shall recognise a financial liability for the consideration received.  In subsequent periods, the entity shall recognise any income on the transferred asset and any expense incurred on the financial liability.

Continuing involvement in transferred assets

3.2.16 If an entity neither transfers nor retains substantially all the risks and rewards of ownership of a transferred asset, and retains control of the transferred asset, the entity continues to recognise the transferred asset to the extent of its continuing involvement.  The extent of the entity’s continuing involvement in the transferred asset is the extent to which it is exposed to changes in the value of the transferred asset.  For example:

(a) When the entity’s continuing involvement takes the form of guaranteeing the transferred asset, the extent of the entity’s continuing involvement is the lower of (i) the amount of the asset and (ii) the maximum amount of the consideration received that the entity could be required to repay (‘the guarantee amount’). 

(b) When the entity’s continuing involvement takes the form of a written or purchased option (or both) on the transferred asset, the extent of the entity’s continuing involvement is the amount of the transferred asset that the entity may repurchase.  However, in the case of a written put option on an asset that is measured at fair value, the extent of the entity’s continuing involvement is limited to the lower of the fair value of the transferred asset and the option exercise price (see paragraph B3.2.13).

(c) When the entity’s continuing involvement takes the form of a cash settled option or similar provision on the transferred asset, the extent of the entity’s continuing involvement is measured in the same way as that which results from non-cash settled options as set out in (b) above. 

3.2.17 When an entity continues to recognise an asset to the extent of its continuing involvement, the entity also recognises an associated liability.  Despite the other measurement requirements in this Standard, the transferred asset and the associated liability are measured on a basis that reflects the rights and obligations that the entity has retained.  The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is:

(a) the amortised cost of the rights and obligations retained by the entity, if the transferred asset is measured at amortised cost, or

(b) equal to the fair value of the rights and obligations retained by the entity when measured on a stand-alone basis, if the transferred asset is measured at fair value.

3.2.18 The entity shall continue to recognise any income arising on the transferred asset to the extent of its continuing involvement and shall recognise any expense incurred on the associated liability.

3.2.19 For the purpose of subsequent measurement, recognised changes in the fair value of the transferred asset and the associated liability are accounted for consistently with each other in accordance with paragraph 5.7.1, and shall not be offset. 

3.2.20 If an entity’s continuing involvement is in only a part of a financial asset (eg when an entity retains an option to repurchase part of a transferred asset, or retains a residual interest that does not result in the retention of substantially all the risks and rewards of ownership and the entity retains control), the entity allocates the previous carrying amount of the financial asset between the part it continues to recognise under continuing involvement, and the part it no longer recognises on the basis of the relative fair values of those parts on the date of the transfer.  For this purpose, the requirements of paragraph 3.2.14 apply.  The difference between:

(a) the carrying amount (measured at the date of derecognition) allocated to the part that is no longer recognised; and

(b) the consideration received for the part no longer recognised;

shall be recognised in profit or loss.

3.2.21 If the transferred asset is measured at amortised cost, the option in this Standard to designate a financial liability as at fair value through profit or loss is not applicable to the associated liability.

All transfers

3.2.22 If a transferred asset continues to be recognised, the asset and the associated liability shall not be offset.  Similarly, the entity shall not offset any income arising from the transferred asset with any expense incurred on the associated liability (see AASB 132 Financial Instruments: Presentation paragraph 42).

3.2.23 If a transferor provides non-cash collateral (such as debt or equity instruments) to the transferee, the accounting for the collateral by the transferor and the transferee depends on whether the transferee has the right to sell or repledge the collateral and on whether the transferor has defaulted.  The transferor and transferee shall account for the collateral as follows:

(a) If the transferee has the right by contract or custom to sell or repledge the collateral, then the transferor shall reclassify that asset in its statement of financial position (eg as a loaned asset, pledged equity instruments or repurchase receivable) separately from other assets.

(b) If the transferee sells collateral pledged to it, it shall recognise the proceeds from the sale and a liability measured at fair value for its obligation to return the collateral.

(c) If the transferor defaults under the terms of the contract and is no longer entitled to redeem the collateral, it shall derecognise the collateral, and the transferee shall recognise the collateral as its asset initially measured at fair value or, if it has already sold the collateral, derecognise its obligation to return the collateral.

(d) Except as provided in (c), the transferor shall continue to carry the collateral as its asset, and the transferee shall not recognise the collateral as an asset.

3.3  Derecognition of financial liabilities

3.3.1 An entity shall remove a financial liability (or a part of a financial liability) from its statement of financial position when, and only when, it is extinguished – ie when the obligation specified in the contract is discharged or cancelled or expires.

3.3.2 An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.  Similarly, a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

3.3.3 The difference between the carrying amount of a financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed, shall be recognised in profit or loss. 

3.3.4  If an entity repurchases a part of a financial liability, the entity shall allocate the previous carrying amount of the financial liability between the part that continues to be recognised and the part that is derecognised based on the relative fair values of those parts on the date of the repurchase.  The difference between (a) the carrying amount allocated to the part derecognised and (b) the consideration paid, including any non-cash assets transferred or liabilities assumed, for the part derecognised shall be recognised in profit or loss. 

Chapter 4  Classification

4.1  Classification of financial assets

4.1.1 Unless paragraph 4.1.5 applies, an entity shall classify financial assets as subsequently measured at either amortised cost or fair value on the basis of both:

(a) the entity’s business model for managing the financial assets; and

(b) the contractual cash flow characteristics of the financial asset.

4.1.2 A financial asset shall be measured at amortised cost if both of the following conditions are met:

(a) The asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.

(b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Paragraphs B4.1.1-B4.1.26 provide guidance on how to apply these conditions.

4.1.3 For the purpose of applying paragraph 4.1.2(b), interest is consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.

4.1.4 A financial asset shall be measured at fair value unless it is measured at amortised cost in accordance with paragraph 4.1.2. 

Option to designate a financial asset at fair value through profit or loss

4.1.5 Despite paragraphs 4.1.1-4.1.4, an entity may, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit or loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases (see paragraphs B4.1.29-B4.1.32).

4.1.6 AASB 7 Financial Instruments: Disclosures requires the entity to provide disclosures about financial assets it has designated as at fair value through profit or loss.

4.2 Classification of financial liabilities

4.2.1 An entity shall classify all financial liabilities as subsequently measured at amortised cost using the effective interest method, except for:

(a) financial liabilities at fair value through profit or loss.  Such liabilities, including derivatives that are liabilities, shall be subsequently measured at fair value. 

(b) financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies.  Paragraphs 3.2.15 and 3.2.17 apply to the measurement of such financial liabilities.

(c) financial guarantee contracts as defined in Appendix A.  After initial recognition, an issuer of such a contract shall (unless paragraph 4.2.1(a) or (b) applies) subsequently measure it at the higher of:

(i) the amount determined in accordance with AASB 137 Provisions, Contingent Liabilities and Contingent Assets; and

(ii) the amount initially recognised (see paragraph 5.1.1) less, when appropriate, the cumulative amount of income recognised in accordance with the principles of AASB 15 Revenue from Contracts with Customers.

(d) commitments to provide a loan at a below-market interest rate.  After initial recognition, an issuer of such a commitment shall (unless paragraph 4.2.1(a) applies) subsequently measure it at the higher of:

(i) the amount determined in accordance with AASB 137; and

(ii) the amount initially recognised (see paragraph 5.1.1) less, when appropriate, the cumulative amount of income recognised in accordance with the principles of AASB 15.

(e) contingent consideration of an acquirer in a business combination to which AASB 3 Business Combinations applies.  Such contingent consideration shall subsequently be measured at fair value.

Option to designate a financial liability at fair value through profit or loss

4.2.2 An entity may, at initial recognition, irrevocably designate a financial liability as measured at fair value through profit or loss when permitted by paragraph 4.3.5, or when doing so results in more relevant information, because either:

(a) it eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as ‘an accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases (see paragraphs B4.1.29-B4.1.32); or

(b) a group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel (as defined in AASB 124 Related Party Disclosures), for example, the entity’s board of directors and chief executive officer (see paragraphs B4.1.33-B4.1.36).

4.2.3 AASB 7 requires the entity to provide disclosures about the financial liabilities it has designated as at fair value through profit or loss.

4.3 Embedded derivatives

4.3.1 An embedded derivative is a component of a hybrid contract that also includes a non-derivative host – with the effect that some of the cash flows of the combined instrument vary in a way similar to a stand-alone derivative.  An embedded derivative causes some or all of the cash flows that otherwise would be required by the contract to be modified according to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.  A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty, is not an embedded derivative, but a separate financial instrument.

Hybrid contracts with financial asset hosts

4.3.2 If a hybrid contract contains a host that is an asset within the scope of this Standard, an entity shall apply the requirements in paragraphs 4.1.1-4.1.5 to the entire hybrid contract.

Other hybrid contracts

4.3.3 If a hybrid contract contains a host that is not an asset within the scope of this Standard, an embedded derivative shall be separated from the host and accounted for as a derivative under this Standard if, and only if:

(a) the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host (see paragraphs B4.3.5 and B4.3.8);

(b) a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and

(c) the hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss (ie a derivative that is embedded in a financial liability at fair value through profit or loss is not separated).

4.3.4 If an embedded derivative is separated, the host contract shall be accounted for in accordance with the appropriate Standard.  This Standard does not address whether an embedded derivative shall be presented separately in the statement of financial position.

4.3.5 Despite paragraphs 4.3.3 and 4.3.4, if a contract contains one or more embedded derivatives and the host is not an asset within the scope of this Standard, an entity may designate the entire hybrid contract as at fair value through profit or loss unless:

(a) the embedded derivative(s) do(es) not significantly modify the cash flows that otherwise would be required by the contract; or

(b) it is clear with little or no analysis when a similar hybrid instrument is first considered that separation of the embedded derivative(s) is prohibited, such as a prepayment option embedded in a loan that permits the holder to prepay the loan for approximately its amortised cost.

4.3.6 If an entity is required by this Standard to separate an embedded derivative from its host, but is unable to measure the embedded derivative separately either at acquisition or at the end of a subsequent financial reporting period, it shall designate the entire hybrid contract as at fair value through profit or loss. 

4.3.7 If an entity is unable to measure reliably the fair value of an embedded derivative on the basis of its terms and conditions, the fair value of the embedded derivative is the difference between the fair value of the hybrid contract and the fair value of the host.  If the entity is unable to measure the fair value of the embedded derivative using this method, paragraph 4.3.6 applies and the hybrid contract is designated as at fair value through profit or loss.

4.4 Reclassification

4.4.1 When, and only when, an entity changes its business model for managing financial assets it shall reclassify all affected financial assets in accordance with paragraphs 4.1.1-4.1.4.

4.4.2  An entity shall not reclassify any financial liability.

4.4.3 The following changes in circumstances are not reclassifications for the purposes of paragraphs 4.4.1-4.4.2:

(a) an item that was previously a designated and effective hedging instrument in a cash flow hedge or net investment hedge no longer qualifies as such;

(b) an item becomes a designated and effective hedging instrument in a cash flow hedge or net investment hedge; and

(c) changes in measurement in accordance with Section 6.7.

Chapter 5  Measurement

5.1 Initial measurement

5.1.1 Except for trade receivables within the scope of paragraph 5.1.3, at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.

5.1.1A However, if the fair value of the financial asset or financial liability at initial recognition differs from the transaction price, an entity shall apply paragraph B5.1.2A.

5.1.2 When an entity uses settlement date accounting for an asset that is subsequently measured at amortised cost, the asset is recognised initially at its fair value on the trade date (see paragraphs B3.1.3-B3.1.6).

5.1.3 Notwithstanding the requirement in paragraph 5.1.1, at initial recognition, an entity shall measure trade receivables that do not have a significant financing component (determined in accordance with AASB 15) at their transaction price (as defined in AASB 15).

5.2 Subsequent measurement of financial assets

5.2.1 After initial recognition, an entity shall measure a financial asset in accordance with paragraphs 4.1.1-4.1.5 at fair value or amortised cost (see paragraphs 9 and AG5-AG8C of AASB 139).

5.2.2 An entity shall apply the impairment requirements in paragraphs 58-65 and AG84-AG93 of AASB 139 to financial assets measured at amortised cost.

5.2.3 An entity shall apply the hedge accounting requirements in paragraphs 6.5.8-6.5.14 (and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk) to a financial asset that is designated as a hedged item.

5.3 Subsequent measurement of financial liabilities

5.3.1 After initial recognition, an entity shall measure a financial liability in accordance with paragraphs 4.2.1-4.2.2 (see paragraphs 9 and AG5-AG8 of AASB 139).

5.3.2  An entity shall apply the hedge accounting requirements in paragraphs 6.5.8-6.5.14 (and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk) to a financial liability that is designated as a hedged item.

5.4.1-5.4.3 [Deleted by the IASB]

5.5 Amortised cost measurement – not used

5.6 Reclassification of financial assets

5.6.1 If an entity reclassifies financial assets in accordance with paragraph 4.4.1, it shall apply the reclassification prospectively from the reclassification date.  The entity shall not restate any previously recognised gains, losses or interest.

5.6.2 If, in accordance with paragraph 4.4.1, an entity reclassifies a financial asset so that it is measured at fair value, its fair value is measured at the reclassification date.  Any gain or loss arising from a difference between the previous carrying amount and fair value is recognised in profit or loss.

5.6.3 If, in accordance with paragraph 4.4.1, an entity reclassifies a financial asset so that it is measured at amortised cost, its fair value at the reclassification date becomes its new carrying amount. 

5.7 Gains and losses

5.7.1 A gain or loss on a financial asset or financial liability that is measured at fair value shall be recognised in profit or loss unless:

(a) it is part of a hedging relationship (see paragraphs 6.5.8-6.5.14 and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk);

(b) it is an investment in an equity instrument and the entity has elected to present gains and losses on that investment in other comprehensive income in accordance with paragraph 5.7.5; or

(c) it is a financial liability designated as at fair value through profit or loss and the entity is required to present the effects of changes in the liability’s credit risk in other comprehensive income in accordance with paragraph 5.7.7.

5.7.1A Dividends are recognised in profit or loss only when:

(a) the entity’s right to receive payment of the dividend is established;

(b) it is probable that the economic benefits associated with the dividend will flow to the entity; and

(c) the amount of the dividend can be measured reliably.

5.7.2 A gain or loss on a financial asset that is measured at amortised cost and is not part of a hedging relationship (see paragraphs 6.5.8-6.5.14 and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk) shall be recognised in profit or loss when the financial asset is derecognised, impaired or reclassified in accordance with paragraph 5.6.2, and through the amortisation process.  A gain or loss on a financial liability that is measured at amortised cost and is not part of a hedging relationship (see paragraphs 6.5.8-6.5.14 and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk) shall be recognised in profit or loss when the financial liability is derecognised and through the amortisation process.

5.7.3 A gain or loss on financial assets or financial liabilities that are hedged items in a hedging relationship shall be recognised in accordance with paragraphs 6.5.8-6.5.14 and, if applicable, paragraphs 89-94 of AASB 139 for the fair value hedge accounting for a portfolio hedge of interest rate risk.

5.7.4 If an entity recognises financial assets using settlement date accounting (see paragraphs 3.1.2, B3.1.3 and B3.1.6), any change in the fair value of the asset to be received during the period between the trade date and the settlement date is not recognised for assets measured at amortised cost (other than impairment losses).  For assets measured at fair value, however, the change in fair value shall be recognised in profit or loss or in other comprehensive income, as appropriate under paragraph 5.7.1.

Investments in equity instruments

5.7.5 At initial recognition, an entity may make an irrevocable election to present in other comprehensive income subsequent changes in the fair value of an investment in an equity instrument within the scope of this Standard that is not held for trading and is also not contingent consideration of an acquirer in a business combination to which AASB 3 applies.

5.7.6 If an entity makes the election in paragraph 5.7.5, it shall recognise in profit or loss dividends from that investment in accordance with paragraph 5.7.1A.

Liabilities designated as at fair value through profit or loss

5.7.7 An entity shall present a gain or loss on a financial liability designated as at fair value through profit or loss as follows:

(a) the amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability shall be presented in other comprehensive income (see paragraphs B5.7.13-B5.7.20); and

(b) the remaining amount of change in the fair value of the liability shall be presented in profit or loss;

unless the treatment of the effects of changes in the liability’s credit risk described in (a) would create or enlarge an accounting mismatch in profit or loss (in which case paragraph 5.7.8 applies).  Paragraphs B5.7.5-B5.7.7 and B5.7.10-B5.7.12 provide guidance on determining whether an accounting mismatch would be created or enlarged.

5.7.8 If the requirements in paragraph 5.7.7 would create or enlarge an accounting mismatch in profit or loss, an entity shall present all gains or losses on that liability (including the effects of changes in the credit risk of that liability) in profit or loss.

5.7.9  Despite the requirements in paragraphs 5.7.7 and 5.7.8, an entity shall present in profit or loss all gains and losses on loan commitments and financial guarantee contracts that are designated as at fair value through profit or loss.

Chapter 6  Hedge accounting

6.1  Objective and scope of hedge accounting

6.1.1 The objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss (or other comprehensive income, in the case of investments in equity instruments for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5).  This approach aims to convey the context of hedging instruments for which hedge accounting is applied in order to allow insight into their purpose and effect.

6.1.2 An entity may choose to designate a hedging relationship between a hedging instrument and a hedged item in accordance with paragraphs 6.2.1-6.3.7 and B6.2.1-B6.3.25.  For hedging relationships that meet the qualifying criteria, an entity shall account for the gain or loss on the hedging instrument and the hedged item in accordance with paragraphs 6.5.1-6.5.14 and B6.5.1-B6.5.28.  When the hedged item is a group of items, an entity shall comply with the additional requirements in paragraphs 6.6.1-6.6.6 and B6.6.1-B6.6.16.

6.1.3 For a fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities (and only for such a hedge), an entity may apply the hedge accounting requirements in AASB 139 instead of those in this Standard.  In that case, the entity must also apply the specific requirements for the fair value hedge accounting for a portfolio hedge of interest rate risk and designate as the hedged item a portion that is a currency amount (see paragraphs 81A, 89A and AG114-AG132 of AASB 139).

6.2  Hedging instruments

Qualifying instruments

6.2.1 A derivative measured at fair value through profit or loss may be designated as a hedging instrument, except for some written options (see paragraph B6.2.4).

6.2.2 A non-derivative financial asset or a non-derivative financial liability measured at fair value through profit or loss may be designated as a hedging instrument unless it is a financial liability designated as at fair value through profit or loss for which the amount of its change in fair value that is attributable to changes in the credit risk of that liability is presented in other comprehensive income in accordance with paragraph 5.7.7.  For a hedge of foreign currency risk, the foreign currency risk component of a non-derivative financial asset or a non-derivative financial liability may be designated as a hedging instrument provided that it is not an investment in an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5.

6.2.3 For hedge accounting purposes, only contracts with a party external to the reporting entity (ie external to the group or individual entity that is being reported on) can be designated as hedging instruments.

Designation of hedging instruments

6.2.4 A qualifying instrument must be designated in its entirety as a hedging instrument.  The only exceptions permitted are:

(a) separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option and not the change in its time value (see paragraphs 6.5.15 and B6.5.29-B6.5.33);

(b) separating the forward element and the spot element of a forward contract and designating as the hedging instrument only the change in the value of the spot element of a forward contract and not the forward element; similarly, the foreign currency basis spread may be separated and excluded from the designation of a financial instrument as the hedging instrument (see paragraphs 6.5.16 and B6.5.34-B6.5.39); and

(c) a proportion of the entire hedging instrument, such as 50 per cent of the nominal amount, may be designated as the hedging instrument in a hedging relationship.  However, a hedging instrument may not be designated for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding.

6.2.5 An entity may view in combination, and jointly designate as the hedging instrument, any combination of the following (including those circumstances in which the risk or risks arising from some hedging instruments offset those arising from others):

(a) derivatives or a proportion of them; and

(b) non-derivatives or a proportion of them.

6.2.6 However, a derivative instrument that combines a written option and a purchased option (for example, an interest rate collar) does not qualify as a hedging instrument if it is, in effect, a net written option at the date of designation (unless it qualifies in accordance with paragraph B6.2.4).  Similarly, two or more instruments (or proportions of them) may be jointly designated as the hedging instrument only if, in combination, they are not, in effect, a net written option at the date of designation (unless it qualifies in accordance with paragraph B6.2.4).

6.3 Hedged items

Qualifying items

6.3.1 A hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation.  The hedged item can be:

(a) a single item; or

(b) a group of items (subject to paragraphs 6.6.1-6.6.6 and B6.6.1-B6.6.16).

 A hedged item can also be a component of such an item or group of items (see paragraphs 6.3.7 and B6.3.7-B6.3.25).

6.3.2 The hedged item must be reliably measurable.

6.3.3 If a hedged item is a forecast transaction (or a component thereof), that transaction must be highly probable.

6.3.4 An aggregated exposure that is a combination of an exposure that could qualify as a hedged item in accordance with paragraph 6.3.1 and a derivative may be designated as a hedged item (see paragraphs B6.3.3-B6.3.4).  This includes a forecast transaction of an aggregated exposure (ie uncommitted but anticipated future transactions that would give rise to an exposure and a derivative) if that aggregated exposure is highly probable and, once it has occurred and is therefore no longer forecast, is eligible as a hedged item.

6.3.5 For hedge accounting purposes, only assets, liabilities, firm commitments or highly probable forecast transactions with a party external to the reporting entity can be designated as hedged items.  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, except for the consolidated financial statements of an investment entity, as defined in AASB 10, where transactions between an investment entity and its subsidiaries measured at fair value through profit or loss will not be eliminated in the consolidated financial statements.

6.3.6 However, as an exception to paragraph 6.3.5, the foreign currency risk of an intragroup monetary item (for example, a payable/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 in accordance with AASB 121 The Effects of Changes in Foreign Exchange Rates.  In accordance with AASB 121, foreign exchange rate gains and losses on intragroup monetary items are not fully eliminated on consolidation when the intragroup monetary item is transacted between two group entities that have different functional currencies.  In addition, the foreign currency risk of a highly probable forecast intragroup transaction may qualify as a hedged item in consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated profit or loss.

Designation of hedged items

6.3.7 An entity may designate an item in its entirety or a component of an item as the hedged item in a hedging relationship.  An entire item comprises all changes in the cash flows or fair value of an item.  A component comprises less than the entire fair value change or cash flow variability of an item.  In that case, an entity may designate only the following types of components (including combinations) as hedged items:

(a) only changes in the cash flows or fair value of an item attributable to a specific risk or risks (risk component), provided that, based on an assessment within the context of the particular market structure, the risk component is separately identifiable and reliably measurable (see paragraphs B6.3.8-B6.3.15).  Risk components include a designation of only changes in the cash flows or the fair value of a hedged item above or below a specified price or other variable (a one-sided risk).

(b) one or more selected contractual cash flows.

(c) components of a nominal amount, ie a specified part of the amount of an item (see paragraphs B6.3.16-B6.3.20).

6.4 Qualifying criteria for hedge accounting

6.4.1 A hedging relationship qualifies for hedge accounting only if all of the following criteria are met:

(a) the hedging relationship consists only of eligible hedging instruments and eligible hedged items.

(b) at the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge.  That documentation shall include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio).

(c) the hedging relationship meets all of the following hedge effectiveness requirements:

(i) there is an economic relationship between the hedged item and the hedging instrument (see paragraphs B6.4.4-B6.4.6);

(ii) the effect of credit risk does not dominate the value changes that result from that economic relationship (see paragraphs B6.4.7-B6.4.8); and

(iii) the hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.  However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting (see paragraphs B6.4.9-B6.4.11).

6.5 Accounting for qualifying hedging relationships

6.5.1 An entity applies hedge accounting to hedging relationships that meet the qualifying criteria in paragraph 6.4.1 (which include the entity’s decision to designate the hedging relationship).

6.5.2 There are three types of hedging relationships:

(a) fair value hedge: a hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.

(b) cash flow hedge: a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all, or a component of, a recognised asset or liability (such as all or some future interest payments on variable-rate debt) or a highly probable forecast transaction, and could affect profit or loss.

(c) hedge of a net investment in a foreign operation as defined in AASB 121.

6.5.3 If the hedged item is an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5, the hedged exposure referred to in paragraph 6.5.2(a) must be one that could affect other comprehensive income.  In that case, and only in that case, the recognised hedge ineffectiveness is presented in other comprehensive income.

6.5.4 A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or a cash flow hedge.

6.5.5 If a hedging relationship ceases to meet the hedge effectiveness requirement relating to the hedge ratio (see paragraph 6.4.1(c)(iii)) but the risk management objective for that designated hedging relationship remains the same, an entity shall adjust the hedge ratio of the hedging relationship so that it meets the qualifying criteria again (this is referred to in this Standard as ‘rebalancing’ – see paragraphs B6.5.7-B6.5.21).

6.5.6 An entity shall discontinue hedge accounting prospectively only when the hedging relationship (or a part of a hedging relationship) ceases to meet the qualifying criteria (after taking into account any rebalancing of the hedging relationship, if applicable).  This includes instances when the hedging instrument expires or is sold, terminated or exercised.  For this purpose, the replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such a replacement or rollover is part of, and consistent with, the entity’s documented risk management objective.  Additionally, for this purpose there is not an expiration or termination of the hedging instrument if:

(a) as a consequence of laws or regulations or the introduction of laws or regulations, the parties to the hedging instrument agree that one or more clearing counterparties replace their original counterparty to become the new counterparty to each of the parties.  For this purpose, a clearing counterparty is a central counterparty (sometimes called a ‘clearing organisation’ or ‘clearing agency’) or an entity or entities, for example, a clearing member of a clearing organisation or a client of a clearing member of a clearing organisation, that are acting as a counterparty in order to effect clearing by a central counterparty.  However, when the parties to the hedging instrument replace their original counterparties with different counterparties the requirement in this subparagraph is met only if each of those parties effects clearing with the same central counterparty.

(b) other changes, if any, to the hedging instrument are limited to those that are necessary to effect such a replacement of the counterparty.  Such changes are limited to those that are consistent with the terms that would be expected if the hedging instrument were originally cleared with the clearing counterparty.  These changes include changes in the collateral requirements, rights to offset receivables and payables balances, and charges levied.

 Discontinuing hedge accounting can either affect a hedging relationship in its entirety or only a part of it (in which case hedge accounting continues for the remainder of the hedging relationship).

6.5.7 An entity shall apply:

(a) paragraph 6.5.10 when it discontinues hedge accounting for a fair value hedge for which the hedged item is (or is a component of) a financial instrument measured at amortised cost; and

(b) paragraph 6.5.12 when it discontinues hedge accounting for cash flow hedges.

Fair value hedges

6.5.8 As long as a fair value hedge meets the qualifying criteria in paragraph 6.4.1, the hedging relationship shall be accounted for as follows:

(a) the gain or loss on the hedging instrument shall be recognised in profit or loss (or other comprehensive income, if the hedging instrument hedges an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5).

(b) the hedging gain or loss on the hedged item shall adjust the carrying amount of the hedged item (if applicable) and be recognised in profit or loss.  However, if the hedged item is an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5, those amounts shall remain in other comprehensive income.  When a hedged item is an unrecognised firm commitment (or a component thereof), the cumulative change in the fair value of the hedged item subsequent to its designation is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss.

6.5.9 When a hedged item in a fair value hedge is a firm commitment (or a component thereof) to acquire an asset or assume a liability, the initial carrying amount of the asset or the liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the hedged item that was recognised in the statement of financial position.

6.5.10  Any adjustment arising from paragraph 6.5.8(b) shall be amortised to profit or loss if the hedged item is a financial instrument (or a component thereof) measured at amortised cost.  Amortisation may begin as soon as an adjustment exists and shall begin no later than when the hedged item ceases to be adjusted for hedging gains and losses.  The amortisation is based on a recalculated effective interest rate at the date that amortisation begins.

Cash flow hedges

6.5.11  As long as a cash flow hedge meets the qualifying criteria in paragraph 6.4.1, the hedging relationship shall be accounted for as follows:

(a) the separate component of equity associated with the hedged item (cash flow hedge reserve) is adjusted to the lower of the following (in absolute amounts):

(i) the cumulative gain or loss on the hedging instrument from inception of the hedge; and

(ii) the cumulative change in fair value (present value) of the hedged item (ie the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.

(b) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (ie the portion that is offset by the change in the cash flow hedge reserve calculated in accordance with (a)) shall be recognised in other comprehensive income.

(c) any remaining gain or loss on the hedging instrument (or any gain or loss required to balance the change in the cash flow hedge reserve calculated in accordance with (a)) is hedge ineffectiveness that shall be recognised in profit or loss.

(d) the amount that has been accumulated in the cash flow hedge reserve in accordance with (a) shall be accounted for as follows:

(i) if a hedged forecast transaction subsequently results in the recognition of a non-financial asset or non-financial liability, or a hedged forecast transaction for a non-financial asset or a non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, the entity shall remove that amount from the cash flow hedge reserve and include it directly in the initial cost or other carrying amount of the asset or the liability.  This is not a reclassification adjustment (see AASB 101 Presentation of Financial Statements) and hence it does not affect other comprehensive income.

(ii) for cash flow hedges other than those covered by (i), that amount shall be reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment (see AASB 101) in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, in the periods that interest income or interest expense is recognised or when a forecast sale occurs).

(iii) however, if that amount is a loss and an entity expects that all or a portion of that loss will not be recovered in one or more future periods, it shall immediately reclassify the amount that is not expected to be recovered into profit or loss as a reclassification adjustment (see AASB 101).

6.5.12  When an entity discontinues hedge accounting for a cash flow hedge (see paragraphs 6.5.6 and 6.5.7(b)) it shall account for the amount that has been accumulated in the cash flow hedge reserve in accordance with paragraph 6.5.11(a) as follows:

(a) if the hedged future cash flows are still expected to occur, that amount shall remain in the cash flow hedge reserve until the future cash flows occur or until paragraph 6.5.11(d)(iii) applies.  When the future cash flows occur, paragraph 6.5.11(d) applies.

(b) if the hedged future cash flows are no longer expected to occur, that amount shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment (see AASB 101).  A hedged future cash flow that is no longer highly probable to occur may still be expected to occur.

Hedges of a net investment in a foreign operation

6.5.13  Hedges of a net investment in a foreign operation, including a hedge of a monetary item that is accounted for as part of the net investment (see AASB 121), shall be accounted for similarly to cash flow hedges:

(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognised in other comprehensive income (see paragraph 6.5.11); and

(b) the ineffective portion shall be recognised in profit or loss.

6.5.14  The cumulative gain or loss on the hedging instrument relating to the effective portion of the hedge that has been accumulated in the foreign currency translation reserve shall be reclassified from equity to profit or loss as a reclassification adjustment (see AASB 101) in accordance with paragraphs 48-49 of AASB 121 on the disposal or partial disposal of the foreign operation.

Accounting for the time value of options

6.5.15  When an entity separates the intrinsic value and time value of an option contract and designates as the hedging instrument only the change in intrinsic value of the option (see paragraph 6.2.4(a)), it shall account for the time value of the option as follows (see paragraphs B6.5.29-B6.5.33):

(a) an entity shall distinguish the time value of options by the type of hedged item that the option hedges (see paragraph B6.5.29):

(i) a transaction related hedged item; or

(ii) a time-period related hedged item.

(b) the change in fair value of the time value of an option that hedges a transaction related hedged item shall be recognised in other comprehensive income to the extent that it relates to the hedged item and shall be accumulated in a separate component of equity.  The cumulative change in fair value arising from the time value of the option that has been accumulated in a separate component of equity (the ‘amount’) shall be accounted for as follows:

(i) if the hedged item subsequently results in the recognition of a non-financial asset or a non-financial liability, or a firm commitment for a non-financial asset or a non-financial liability for which fair value hedge accounting is applied, the entity shall remove the amount from the separate component of equity and include it directly in the initial cost or other carrying amount of the asset or the liability.  This is not a reclassification adjustment (see AASB 101) and hence does not affect other comprehensive income.

(ii) for hedging relationships other than those covered by (i), the amount shall be reclassified from the separate component of equity to profit or loss as a reclassification adjustment (see AASB 101) in the same period or periods during which the hedged expected future cash flows affect profit or loss (for example, when a forecast sale occurs).

(iii) however, if all or a portion of that amount is not expected to be recovered in one or more future periods, the amount that is not expected to be recovered shall be immediately reclassified into profit or loss as a reclassification adjustment (see AASB 101).

(c) the change in fair value of the time value of an option that hedges a time-period related hedged item shall be recognised in other comprehensive income to the extent that it relates to the hedged item and shall be accumulated in a separate component of equity.  The time value at the date of designation of the option as a hedging instrument, to the extent that it relates to the hedged item, shall be amortised on a systematic and rational basis over the period during which the hedge adjustment for the option’s intrinsic value could affect profit or loss (or other comprehensive income, if the hedged item is an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5).  Hence, in each reporting period, the amortisation amount shall be reclassified from the separate component of equity to profit or loss as a reclassification adjustment (see AASB 101).  However, if hedge accounting is discontinued for the hedging relationship that includes the change in intrinsic value of the option as the hedging instrument, the net amount (ie including cumulative amortisation) that has been accumulated in the separate component of equity shall be immediately reclassified into profit or loss as a reclassification adjustment (see AASB 101).

Accounting for the forward element of forward contracts and foreign currency basis spreads of financial instruments

6.5.16  When an entity separates the forward element and the spot element of a forward contract and designates as the hedging instrument only the change in the value of the spot element of the forward contract, or when an entity separates the foreign currency basis spread from a financial instrument and excludes it from the designation of that financial instrument as the hedging instrument (see paragraph 6.2.4(b)), the entity may apply paragraph 6.5.15 to the forward element of the forward contract or to the foreign currency basis spread in the same manner as it is applied to the time value of an option.  In that case, the entity shall apply the application guidance in paragraphs B6.5.34-B6.5.39.

6.6 Hedges of a group of items

Eligibility of a group of items as the hedged item

6.6.1 A group of items (including a group of items that constitute a net position; see paragraphs B6.6.1-B6.6.8) is an eligible hedged item only if:

(a) it consists of items (including components of items) that are, individually, eligible hedged items;

(b) the items in the group are managed together on a group basis for risk management purposes; and

(c) in the case of a cash flow hedge of a group of items whose variabilities in cash flows are not expected to be approximately proportional to the overall variability in cash flows of the group so that offsetting risk positions arise:

(i) it is a hedge of foreign currency risk; and

(ii) the designation of that net position specifies the reporting period in which the forecast transactions are expected to affect profit or loss, as well as their nature and volume (see paragraphs B6.6.7-B6.6.8).

Designation of a component of a nominal amount

6.6.2 A component that is a proportion of an eligible group of items is an eligible hedged item provided that designation is consistent with the entity’s risk management objective.

6.6.3 A layer component of an overall group of items (for example, a bottom layer) is eligible for hedge accounting only if:

(a) it is separately identifiable and reliably measurable;

(b) the risk management objective is to hedge a layer component;

(c) the items in the overall group from which the layer is identified are exposed to the same hedged risk (so that the measurement of the hedged layer is not significantly affected by which particular items from the overall group form part of the hedged layer);

(d) for a hedge of existing items (for example, an unrecognised firm commitment or a recognised asset) an entity can identify and track the overall group of items from which the hedged layer is defined (so that the entity is able to comply with the requirements for the accounting for qualifying hedging relationships); and

(e) any items in the group that contain prepayment options meet the requirements for components of a nominal amount (see paragraph B6.3.20).

Presentation

6.6.4 For a hedge of a group of items with offsetting risk positions (ie in a hedge of a net position) whose hedged risk affects different line items in the statement of profit or loss and other comprehensive income, any hedging gains or losses in that statement shall be presented in a separate line from those affected by the hedged items.  Hence, in that statement the amount in the line item that relates to the hedged item itself (for example, revenue or cost of sales) remains unaffected.

6.6.5 For assets and liabilities that are hedged together as a group in a fair value hedge, the gain or loss in the statement of financial position on the individual assets and liabilities shall be recognised as an adjustment of the carrying amount of the respective individual items comprising the group in accordance with paragraph 6.5.8(b).

Nil net positions

6.6.6 When the hedged item is a group that is a nil net position (ie the hedged items among themselves fully offset the risk that is managed on a group basis), an entity is permitted to designate it in a hedging relationship that does not include a hedging instrument, provided that:

(a) the hedge is part of a rolling net risk hedging strategy, whereby the entity routinely hedges new positions of the same type as time moves on (for example, when transactions move into the time horizon for which the entity hedges);

(b) the hedged net position changes in size over the life of the rolling net risk hedging strategy and the entity uses eligible hedging instruments to hedge the net risk (ie when the net position is not nil);

(c) hedge accounting is normally applied to such net positions when the net position is not nil and it is hedged with eligible hedging instruments; and

(d) not applying hedge accounting to the nil net position would give rise to inconsistent accounting outcomes, because the accounting would not recognise the offsetting risk positions that would otherwise be recognised in a hedge of a net position.

6.7 Option to designate a credit exposure as measured at fair value through profit or loss

Eligibility of credit exposures for designation at fair value through profit or loss

6.7.1 If an entity uses a credit derivative that is measured at fair value through profit or loss to manage the credit risk of all, or a part of, a financial instrument (credit exposure) it may designate that financial instrument to the extent that it is so managed (ie all or a proportion of it) as measured at fair value through profit or loss if:

(a) the name of the credit exposure (for example, the borrower, or the holder of a loan commitment) matches the reference entity of the credit derivative (‘name matching’); and

(b) the seniority of the financial instrument matches that of the instruments that can be delivered in accordance with the credit derivative.

 An entity may make this designation irrespective of whether the financial instrument that is managed for credit risk is within the scope of this Standard (for example, an entity may designate loan commitments that are outside the scope of this Standard).  The entity may designate that financial instrument at, or subsequent to, initial recognition, or while it is unrecognised.  The entity shall document the designation concurrently.

Accounting for credit exposures designated at fair value through profit or loss

6.7.2 If a financial instrument is designated in accordance with paragraph 6.7.1 as measured at fair value through profit or loss after its initial recognition, or was previously not recognised, the difference at the time of designation between the carrying amount, if any, and the fair value shall immediately be recognised in profit or loss.

6.7.3 An entity shall discontinue measuring the financial instrument that gave rise to the credit risk, or a proportion of that financial instrument, at fair value through profit or loss if:

(a) the qualifying criteria in paragraph 6.7.1 are no longer met, for example:

(i) the credit derivative or the related financial instrument that gives rise to the credit risk expires or is sold, terminated or settled; or

(ii) the credit risk of the financial instrument is no longer managed using credit derivatives.  For example, this could occur because of improvements in the credit quality of the borrower or the loan commitment holder or changes to capital requirements imposed on an entity; and

(b) the financial instrument that gives rise to the credit risk is not otherwise required to be measured at fair value through profit or loss (ie the entity’s business model has not changed in the meantime so that a reclassification in accordance with paragraph 4.4.1 was required).

6.7.4 When an entity discontinues measuring the financial instrument that gives rise to the credit risk, or a proportion of that financial instrument, at fair value through profit or loss, that financial instrument’s fair value at the date of discontinuation becomes its new carrying amount.  Subsequently, the same measurement that was used before designating the financial instrument at fair value through profit or loss shall be applied (including amortisation that results from the new carrying amount).  For example, a financial asset that had originally been classified as measured at amortised cost would revert to that measurement and its effective interest rate would be recalculated based on its new carrying amount on the date of discontinuing measurement at fair value through profit or loss.  Similarly, a loan commitment or a financial guarantee contract would be measured at the higher of:

(a) the amount determined in accordance with AASB 137; and

(b) the new carrying amount at the date of discontinuation less cumulative amortisation.  The amortisation period is the remaining life of the instrument.

Chapter 7  Effective date and transition

7.1 Effective Date

7.1.1 [Deleted by the AASB – see paragraph Aus1.3 and Aus1.4]

7.1.2 Despite the requirements in paragraphs Aus1.3 and Aus1.4, for annual reporting periods beginning before 1 January 2018, an entity may elect to apply the requirements for the presentation of gains and losses on financial liabilities designated as at fair value through profit or loss in paragraphs 5.7.1(c), 5.7.7-5.7.9, 7.2.13 and B5.7.5-B5.7.20 without applying the other requirements in this Standard.  If an entity elects to apply only those paragraphs, it shall disclose that fact and provide on an ongoing basis the related disclosures set out in paragraphs 10‑11 of AASB 7 (as amended by AASB 2010‑7 Amendments to Australian Accounting Standards arising from AASB 9 (December 2010)).

7.1.3 AASB 2014-1 Amendments to Australian Accounting Standards, issued in June 2014, amended paragraphs 4.2.1 and 5.7.5 as a consequential amendment derived from the amendments to paragraphs 40, 58 and 67A of AASB 3.  An entity shall apply that amendment prospectively to business combinations to which the amendment to AASB 3 applies.

7.1.4 AASB 2014-5 Amendments to Australian Accounting Standards arising from AASB 15, issued in December 2014, amended paragraphs 3.1.1, 4.2.1, 5.1.1, 5.2.1, 5.7.6, B3.2.13 and B5.7.1.  Paragraphs 5.1.3 and 5.7.1A, and a definition to Appendix A, were added.  An entity shall apply those amendments when it applies AASB 15.

7.2 Transition

7.2.1  An entity shall apply this Standard retrospectively, in accordance with AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors, except as specified in paragraphs 7.2.4-7.2.15 and 7.2.16-7.2.21.  This Standard shall not be applied to items that have already been derecognised at the date of initial application.

7.2.2 For the purposes of the transition provisions in paragraphs 7.2.1, 7.2.3-7.2.15 and 7.2.18, the date of initial application is the date when an entity first applies those requirements of this Standard.  The date of initial application is the beginning of the first reporting period in which the entity adopts those requirements.  Depending on the entity’s chosen approach to applying AASB 9, the transition can involve one or several dates of initial application for different requirements.

7.2.3 At the date of initial application, an entity shall assess whether a financial asset meets the condition in paragraph 4.1.2(a) on the basis of the facts and circumstances that exist at that date.  The resulting classification shall be applied retrospectively irrespective of the entity’s business model in prior reporting periods.

7.2.4 If an entity measures a hybrid contract at fair value in accordance with paragraphs 4.1.4 or 4.1.5 but the fair value of the hybrid contract had not been measured in comparative reporting periods, the fair value of the hybrid contract in the comparative reporting periods shall be the sum of the fair values of the components (ie the non-derivative host and the embedded derivative) at the end of each comparative reporting period.

7.2.5 At the date of initial application, an entity shall recognise any difference between the fair value of the entire hybrid contract at the date of initial application and the sum of the fair values of the components of the hybrid contract at the date of initial application:

(a) in the opening retained earnings of the reporting period of initial application if the entity initially applies this Standard at the beginning of a reporting period; or

(b) in profit or loss if the entity initially applies this Standard during a reporting period.

7.2.6 At the date of initial application an entity may designate:

(a) a financial asset as measured at fair value through profit or loss in accordance with paragraph 4.1.5; or

(b) an investment in an equity instrument as at fair value through other comprehensive income in accordance with paragraph 5.7.5.

Such designation shall be made on the basis of the facts and circumstances that exist at the date of initial application.  That classification shall be applied retrospectively.

7.2.7 At the date of initial application an entity:

(a) shall revoke its previous designation of a financial asset as measured at fair value through profit or loss if that financial asset does not meet the condition in paragraph 4.1.5.

(b) may revoke its previous designation of a financial asset as measured at fair value through profit or loss if that financial asset meets the condition in paragraph 4.1.5.

Such revocation shall be made on the basis of the facts and circumstances that exist at the date of initial application.  That classification shall be applied retrospectively.

7.2.8 At the date of initial application, an entity:

(a) may designate a financial liability as measured at fair value through profit or loss in accordance with paragraph 4.2.2(a).

(b) shall revoke its previous designation of a financial liability as measured at fair value through profit or loss if such designation was made at initial recognition in accordance with the condition now in paragraph 4.2.2(a) and such designation does not satisfy that condition at the date of initial application.

(c) may revoke its previous designation of a financial liability as measured at fair value through profit or loss if such designation was made at initial recognition in accordance with the condition now in paragraph 4.2.2(a) and such designation satisfies that condition at the date of initial application.

Such designation and revocation shall be made on the basis of the facts and circumstances that exist at the date of initial application.  That classification shall be applied retrospectively.

7.2.9  If it is impracticable (as defined in AASB 108) for an entity to apply retrospectively the effective interest method or the impairment requirements in paragraphs 58-65 and AG84-AG93 of AASB 139, the entity shall treat:

(a) the fair value of the financial asset or the financial liability at the end of each comparative period presented as its amortised cost if the entity restates prior periods;

(b) the fair value of the financial asset or the financial liability at the date of initial application as the new amortised cost of that financial asset or financial liability at the date of initial application of this Standard.

7.2.10 If an entity previously accounted at cost in accordance with AASB 139, for an investment in an equity instrument that does not have a quoted price in an active market for an identical instrument (ie a Level 1 input) (or for a derivative asset that is linked to and must be settled by delivery of such an equity instrument) it shall measure that instrument at fair value at the date of initial application.  Any difference between the previous carrying amount and the fair value shall be recognised in the opening retained earnings of the reporting period that includes the date of initial application.

7.2.11  If an entity previously accounted for a derivative liability that is linked to, and must be settled by, delivery of an equity instrument that does not have a quoted price in an active market for an identical instrument (ie a Level 1 input) at cost in accordance with AASB 139, it shall measure that derivative liability at fair value at the date of initial application.  Any difference between the previous carrying amount and the fair value shall be recognised in the opening retained earnings of the reporting period that includes the date of initial application.

7.2.12 At the date of initial application, an entity shall determine whether the treatment in paragraph 5.7.7 would create or enlarge an accounting mismatch in profit or loss on the basis of the facts and circumstances that exist at the date of initial application.  This Standard shall be applied retrospectively on the basis of that determination.

7.2.13 Despite the requirement in paragraph 7.2.1, an entity that adopts the classification and measurement requirements of this Standard shall provide the disclosures set out in paragraphs 44S-44W of AASB 7 but need not restate prior periods.  The entity may restate prior periods if, and only if, it is possible without the use of hindsight.  If an entity does not restate prior periods, the entity shall recognise any difference between the previous carrying amount and the carrying amount at the beginning of the annual reporting period that includes the date of initial application in the opening retained earnings (or other component of equity, as appropriate) of the annual reporting period that includes the date of initial application.  However, if an entity restates prior periods, the restated financial statements must reflect all of the requirements in this Standard.

7.2.14 If an entity prepares interim financial reports in accordance with AASB 134 Interim Financial Reporting the entity need not apply the requirements in this Standard to interim periods prior to the date of initial application if it is impracticable (as defined in AASB 108).

Entities that have applied AASB 9 (2009) or AASB 9 (2010) early

7.2.15 An entity shall apply the transition requirements in paragraphs 7.2.1-7.2.14 at the relevant date of initial application.  An entity shall apply each of the transition provisions in paragraphs 7.2.3-7.2.12 only once (ie if an entity chooses an approach of applying AASB 9 that involves several dates of initial application, it cannot apply any of those provisions again if they were already applied at an earlier date).

Transition for hedge accounting (Chapter 6)

7.2.16 When an entity first applies this Standard as amended in December 2013, it may choose as its accounting policy to continue to apply the hedge accounting requirements of AASB 139 instead of the requirements in Chapter 6 of this Standard.  An entity shall apply that policy to all of its hedging relationships.  An entity that chooses that policy shall also apply Interpretation 16 Hedges of a Net Investment in a Foreign Operation (as identified in AASB 1048 Interpretation of Standards) without the amendments that conform that Interpretation to the requirements in Chapter 6 of this Standard.

7.2.17 Except as provided in paragraph 7.2.21, an entity shall apply the hedge accounting requirements of this Standard prospectively.

7.2.18 To apply hedge accounting from the date of initial application of the hedge accounting requirements of this Standard, all qualifying criteria must be met as at that date.

7.2.19 Hedging relationships that qualified for hedge accounting in accordance with AASB 139 that also qualify for hedge accounting in accordance with the criteria of this Standard (see paragraph 6.4.1), after taking into account any rebalancing of the hedging relationship on transition (see paragraph 7.2.20(b)), shall be regarded as continuing hedging relationships.

7.2.20 On initial application of the hedge accounting requirements of this Standard, an entity:

(a) may start to apply those requirements from the same point in time as it ceases to apply the hedge accounting requirements of AASB 139; and

(b) shall consider the hedge ratio in accordance with AASB 139 as the starting point for rebalancing the hedge ratio of a continuing hedging relationship, if applicable.  Any gain or loss from such a rebalancing shall be recognised in profit or loss.

7.2.21 As an exception to prospective application of the hedge accounting requirements of this Standard, an entity:

(a) shall apply the accounting for the time value of options in accordance with paragraph 6.5.15 retrospectively if, in accordance with AASB 139, only the change in an option’s intrinsic value was designated as a hedging instrument in a hedging relationship.  This retrospective application applies only to those hedging relationships that existed at the beginning of the earliest comparative period or were designated thereafter.

(b) may apply the accounting for the forward element of forward contracts in accordance with paragraph 6.5.16 retrospectively if, in accordance with AASB 139, only the change in the spot element of a forward contract was designated as a hedging instrument in a hedging relationship.  This retrospective application applies only to those hedging relationships that existed at the beginning of the earliest comparative period or were designated thereafter.  In addition, if an entity elects retrospective application of this accounting, it shall be applied to all hedging relationships that qualify for this election (ie on transition this election is not available on a hedging-relationship-by-hedging-relationship basis).  The accounting for foreign currency basis spreads (see paragraph 6.5.16) may be applied retrospectively for those hedging relationships that existed at the beginning of the earliest comparative period or were designated thereafter.

(c) shall apply retrospectively the requirement of paragraph 6.5.6 that there is not an expiration or termination of the hedging instrument if:

(i) as a consequence of laws or regulations, or the introduction of laws or regulations, the parties to the hedging instrument agree that one or more clearing counterparties replace their original counterparty to become the new counterparty to each of the parties; and

(ii) other changes, if any, to the hedging instrument are limited to those that are necessary to effect such a replacement of the counterparty.

7.3  Withdrawal of IFRIC 9, IFRS 9 (2009) and IFRS 9 (2010)

7.3.1 [Deleted by the AASB – see paragraph Aus1.8]

7.3.2 [Deleted by the AASB – see paragraph Aus1.7]

APPENDIX A

Defined Terms

This appendix is an integral part of AASB 9.

The following terms are defined in paragraph 11 of AASB 132, paragraph 9 of AASB 139 or Appendix A of AASB 7 and are used in this Standard with the meanings specified in AASB 132, AASB 139 or AASB 7:

(a)       amortised cost of a financial asset or financial liability;

(b)       credit risk;

(c)       effective interest method;

(d)       effective interest rate;

(d) equity instrument;

(e) financial asset;

(f) financial instrument;

(g) financial liability;

(h) transaction costs.

APPENDIX B

application guidance

This appendix is an integral part of AASB 9.

Recognition and derecognition (chapter 3)

Initial recognition (section 3.1)

B3.1.1 As a consequence of the principle in paragraph 3.1.1, an entity recognises all of its contractual rights and obligations under derivatives in its statement of financial position as assets and liabilities, respectively, except for derivatives that prevent a transfer of financial assets from being accounted for as a sale (see paragraph B3.2.14).  If a transfer of a financial asset does not qualify for derecognition, the transferee does not recognise the transferred asset as its asset (see paragraph B3.2.15).

B3.1.2 The following are examples of applying the principle in paragraph 3.1.1:

(a) Unconditional receivables and payables are recognised as assets or liabilities when the entity becomes a party to the contract and, as a consequence, has a legal right to receive or a legal obligation to pay cash.

(b) Assets to be acquired and liabilities to be incurred as a result of a firm commitment to purchase or sell goods or services are generally not recognised until at least one of the parties has performed under the agreement.  For example, an entity that receives a firm order does not generally recognise an asset (and the entity that places the order does not recognise a liability) at the time of the commitment but, rather, delays recognition until the ordered goods or services have been shipped, delivered or rendered.  If a firm commitment to buy or sell non-financial items is within the scope of this Standard in accordance with paragraphs 5-7 of AASB 139, its net fair value is recognised as an asset or a liability on the commitment date (see B4.1.30(c)).  In addition, if a previously unrecognised firm commitment is designated as a hedged item in a fair value hedge, any change in the net fair value attributable to the hedged risk is recognised as an asset or a liability after the inception of the hedge (see paragraphs 6.5.8(b) and 6.5.9).

(c) A forward contract that is within the scope of this Standard (see paragraph 2.1) is recognised as an asset or a liability on the commitment date, rather than on the date on which settlement takes place.  When an entity becomes a party to a forward contract, the fair values of the right and obligation are often equal, so that the net fair value of the forward is zero.  If the net fair value of the right and obligation is not zero, the contract is recognised as an asset or liability.

(d) Option contracts that are within the scope of this Standard (see paragraph 2.1) are recognised as assets or liabilities when the holder or writer becomes a party to the contract.

(e) Planned future transactions, no matter how likely, are not assets and liabilities because the entity has not become a party to a contract.

Regular way purchase or sale of financial assets

B3.1.3 A regular way purchase or sale of financial assets is recognised using either trade date accounting or settlement date accounting as described in paragraphs B3.1.5 and B3.1.6.  An entity shall apply the same method consistently for all purchases and sales of financial assets that are classified in the same way in accordance with this Standard.  For this purpose assets that are mandatorily measured at fair value through profit or loss form a separate classification from assets designated as measured at fair value through profit or loss.  In addition, investments in equity instruments accounted for using the option provided in paragraph 5.7.5 form a separate classification.

B3.1.4 A contract that requires or permits net settlement of the change in the value of the contract is not a regular way contract.  Instead, such a contract is accounted for as a derivative in the period between the trade date and the settlement date.

B3.1.5 The trade date is the date that an entity commits itself to purchase or sell an asset.  Trade date accounting refers to (a) the recognition of an asset to be received and the liability to pay for it on the trade date, and (b) derecognition of an asset that is sold, recognition of any gain or loss on disposal and the recognition of a receivable from the buyer for payment on the trade date.  Generally, interest does not start to accrue on the asset and corresponding liability until the settlement date when title passes.

B3.1.6 The settlement date is the date that an asset is delivered to or by an entity.  Settlement date accounting refers to (a) the recognition of an asset on the day it is received by the entity, and (b) the derecognition of an asset and recognition of any gain or loss on disposal on the day that it is delivered by the entity.  When settlement date accounting is applied an entity accounts for any change in the fair value of the asset to be received during the period between the trade date and the settlement date in the same way as it accounts for the acquired asset.  In other words, the change in value is not recognised for assets measured at amortised cost; it is recognised in profit or loss for assets classified as financial assets measured at fair value through profit or loss; and it is recognised in other comprehensive income for investments in equity instruments accounted for in accordance with paragraph 5.7.5.

Derecognition of financial assets (section 3.2)

B3.2.1 The following flow chart illustrates the evaluation of whether and to what extent a financial asset is derecognised.

Arrangements under which an 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 (paragraph 3.2.4(b))

B3.2.2 The situation described in paragraph 3.2.4(b) (when an entity retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients) occurs, for example, if the entity is a trust, and issues to investors beneficial interests in the underlying financial assets that it owns and provides servicing of those financial assets.  In that case, the financial assets qualify for derecognition if the conditions in paragraphs 3.2.5 and 3.2.6 are met.

B3.2.3 In applying paragraph 3.2.5, the entity could be, for example, the originator of the financial asset, or it could be a group that includes a subsidiary that has acquired the financial asset and passes on cash flows to unrelated third party investors.

Evaluation of the transfer of risks and rewards of ownership (paragraph 3.2.6)

B3.2.4 Examples of when an entity has transferred substantially all the risks and rewards of ownership are:

(a) an unconditional sale of a financial asset;

(b) a sale of a financial asset together with an option to repurchase the financial asset at its fair value at the time of repurchase; and

(c) a sale of a financial asset together with a put or call option that is deeply out of the money (ie an option that is so far out of the money it is highly unlikely to go into the money before expiry).

B3.2.5 Examples of when an entity has retained substantially all the risks and rewards of ownership are:

(a) a sale and repurchase transaction where the repurchase price is a fixed price or the sale price plus a lender’s return;

(b) a securities lending agreement;

(c) a sale of a financial asset together with a total return swap that transfers the market risk exposure back to the entity;

(d) a sale of a financial asset together with a deep in-the-money put or call option (ie an option that is so far in the money that it is highly unlikely to go out of the money before expiry); and

(e) a sale of short-term receivables in which the entity guarantees to compensate the transferee for credit losses that are likely to occur.

B3.2.6 If an entity determines that as a result of the transfer, it has transferred substantially all the risks and rewards of ownership of the transferred asset, it does not recognise the transferred asset again in a future period, unless it reacquires the transferred asset in a new transaction.

Evaluation of the transfer of control

B3.2.7 An entity has not retained control of a transferred asset if the transferee has the practical ability to sell the transferred asset.  An entity has retained control of a transferred asset if the transferee does not have the practical ability to sell the transferred asset.  A transferee has the practical ability to sell the transferred asset if it is traded in an active market because the transferee could repurchase the transferred asset in the market if it needs to return the asset to the entity.  For example, a transferee may have the practical ability to sell a transferred asset if the transferred asset is subject to an option that allows the entity to repurchase it, but the transferee can readily obtain the transferred asset in the market if the option is exercised.  A transferee does not have the practical ability to sell the transferred asset if the entity retains such an option and the transferee cannot readily obtain the transferred asset in the market if the entity exercises its option.

B3.2.8 The transferee has the practical ability to sell the transferred asset only if the transferee can sell the transferred asset in its entirety to an unrelated third party and is able to exercise that ability unilaterally and without imposing additional restrictions on the transfer.  The critical question is what the transferee is able to do in practice, not what contractual rights the transferee has concerning what it can do with the transferred asset or what contractual prohibitions exist.  In particular:

(a) a contractual right to dispose of the transferred asset has little practical effect if there is no market for the transferred asset, and

(b) an ability to dispose of the transferred asset has little practical effect if it cannot be exercised freely.  For that reason:

(i) the transferee’s ability to dispose of the transferred asset must be independent of the actions of others (ie it must be a unilateral ability), and

(ii) the transferee must be able to dispose of the transferred asset without needing to attach restrictive conditions or ‘strings’ to the transfer (eg conditions about how a loan asset is serviced or an option giving the transferee the right to repurchase the asset).

B3.2.9 That the transferee is unlikely to sell the transferred asset does not, of itself, mean that the transferor has retained control of the transferred asset.  However, if a put option or guarantee constrains the transferee from selling the transferred asset, then the transferor has retained control of the transferred asset.  For example, if a put option or guarantee is sufficiently valuable it constrains the transferee from selling the transferred asset because the transferee would, in practice, not sell the transferred asset to a third party without attaching a similar option or other restrictive conditions.  Instead, the transferee would hold the transferred asset so as to obtain payments under the guarantee or put option.  Under these circumstances the transferor has retained control of the transferred asset.

Transfers that qualify for derecognition

B3.2.10 An entity may retain the right to a part of the interest payments on transferred assets as compensation for servicing those assets.  The part of the interest payments that the entity would give up upon termination or transfer of the servicing contract is allocated to the servicing asset or servicing liability.  The part of the interest payments that the entity would not give up is an interest-only strip receivable.  For example, if the entity would not give up any interest upon termination or transfer of the servicing contract, the entire interest spread is an interest-only strip receivable.  For the purposes of applying paragraph 3.2.13, the fair values of the servicing asset and interest-only strip receivable are used to allocate the carrying amount of the receivable between the part of the asset that is derecognised and the part that continues to be recognised.  If there is no servicing fee specified or the fee to be received is not expected to compensate the entity adequately for performing the servicing, a liability for the servicing obligation is recognised at fair value.

B3.2.11 When measuring the fair values of the part that continues to be recognised and the part that is derecognised for the purposes of applying paragraph 3.2.13, an entity applies the fair value measurement requirements in AASB 13 in addition to paragraph 3.2.14.

Transfers that do not qualify for derecognition

B3.2.12 The following is an application of the principle outlined in paragraph 3.2.15.  If a guarantee provided by the entity for default losses on the transferred asset prevents a transferred asset from being derecognised because the entity has retained substantially all the risks and rewards of ownership of the transferred asset, the transferred asset continues to be recognised in its entirety and the consideration received is recognised as a liability.

Continuing involvement in transferred assets

B3.2.13 The following are examples of how an entity measures a transferred asset and the associated liability under paragraph 3.2.16.

All assets

(a) If a guarantee provided by an entity to pay for default losses on a transferred asset prevents the transferred asset from being derecognised to the extent of the continuing involvement, the transferred asset at the date of the transfer is measured at the lower of (i) the carrying amount of the asset and (ii) the maximum amount of the consideration received in the transfer that the entity could be required to repay (‘the guarantee amount’).  The associated liability is initially measured at the guarantee amount plus the fair value of the guarantee (which is normally the consideration received for the guarantee). Subsequently, the initial fair value of the guarantee is recognised in profit or loss when (or as) the obligation is satisfied (in accordance with the principles of AASB 15) and the carrying value of the asset is reduced by any impairment losses.

Assets measured at amortised cost

(b) If a put option obligation written by an entity or call option right held by an entity prevents a transferred asset from being derecognised and the entity measures the transferred asset at amortised cost, the associated liability is measured at its cost (ie the consideration received) adjusted for the amortisation of any difference between that cost and the amortised cost of the transferred asset at the expiration date of the option.  For example, assume that the amortised cost and carrying amount of the asset on the date of the transfer is CU98 and that the consideration received is CU95.  The amortised cost of the asset on the option exercise date will be CU100.  The initial carrying amount of the associated liability is CU95 and the difference between CU95 and CU100 is recognised in profit or loss using the effective interest method.  If the option is exercised, any difference between the carrying amount of the associated liability and the exercise price is recognised in profit or loss.

Assets measured at fair value

(c) If a call option right retained by an entity prevents a transferred asset from being derecognised and the entity measures the transferred asset at fair value, the asset continues to be measured at its fair value.  The associated liability is measured at (i) the option exercise price less the time value of the option if the option is in or at the money, or (ii) the fair value of the transferred asset less the time value of the option if the option is out of the money.  The adjustment to the measurement of the associated liability ensures that the net carrying amount of the asset and the associated liability is the fair value of the call option right.  For example, if the fair value of the underlying asset is CU80, the option exercise price is CU95 and the time value of the option is CU5, the carrying amount of the associated liability is CU75 (CU80 – CU5) and the carrying amount of the transferred asset is CU80 (ie its fair value).

(d) If a put option written by an entity prevents a transferred asset from being derecognised and the entity measures the transferred asset at fair value, the associated liability is measured at the option exercise price plus the time value of the option.  The measurement of the asset at fair value is limited to the lower of the fair value and the option exercise price because the entity has no right to increases in the fair value of the transferred asset above the exercise price of the option.  This ensures that the net carrying amount of the asset and the associated liability is the fair value of the put option obligation.  For example, if the fair value of the underlying asset is CU120, the option exercise price is CU100 and the time value of the option is CU5, the carrying amount of the associated liability is CU105 (CU100 + CU5) and the carrying amount of the asset is CU100 (in this case the option exercise price).

(e) If a collar, in the form of a purchased call and written put, prevents a transferred asset from being derecognised and the entity measures the asset at fair value, it continues to measure the asset at fair value.  The associated liability is measured at (i) the sum of the call exercise price and fair value of the put option less the time value of the call option, if the call option is in or at the money, or (ii) the sum of the fair value of the asset and the fair value of the put option less the time value of the call option if the call option is out of the money.  The adjustment to the associated liability ensures that the net carrying amount of the asset and the associated liability is the fair value of the options held and written by the entity.  For example, assume an entity transfers a financial asset that is measured at fair value while simultaneously purchasing a call with an exercise price of CU120 and writing a put with an exercise price of CU80.  Assume also that the fair value of the asset is CU100 at the date of the transfer.  The time value of the put and call are CU1 and CU5 respectively.  In this case, the entity recognises an asset of CU100 (the fair value of the asset) and a liability of CU96
[(CU100 + CU1) – CU5].  This gives a net asset value of CU4, which is the fair value of the options held and written by the entity.

All transfers

B3.2.14 To the extent that a transfer of a financial asset does not qualify for derecognition, the transferor’s contractual rights or obligations related to the transfer are not accounted for separately as derivatives if recognising both the derivative and either the transferred asset or the liability arising from the transfer would result in recognising the same rights or obligations twice.  For example, a call option retained by the transferor may prevent a transfer of financial assets from being accounted for as a sale.  In that case, the call option is not separately recognised as a derivative asset.

B3.2.15 To the extent that a transfer of a financial asset does not qualify for derecognition, the transferee does not recognise the transferred asset as its asset.  The transferee derecognises the cash or other consideration paid and recognises a receivable from the transferor.  If the transferor has both a right and an obligation to reacquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement), the transferee may measure its receivable at amortised cost if it meets the criteria in paragraph 4.1.2.

Examples

B3.2.16 The following examples illustrate the application of the derecognition principles of this Standard. 

(a) Repurchase agreements and securities lending.  If a financial asset is sold under an agreement to repurchase it at a fixed price or at the sale price plus a lender’s return or if it is loaned under an agreement to return it to the transferor, it is not derecognised because the transferor retains substantially all the risks and rewards of ownership.  If the transferee obtains the right to sell or pledge the asset, the transferor reclassifies the asset in its statement of financial position, for example, as a loaned asset or repurchase receivable.

(b) Repurchase agreements and securities lending – assets that are substantially the same.  If a financial asset is sold under an agreement to repurchase the same or substantially the same asset at a fixed price or at the sale price plus a lender’s return or if a financial asset is borrowed or loaned under an agreement to return the same or substantially the same asset to the transferor, it is not derecognised because the transferor retains substantially all the risks and rewards of ownership.

(c) Repurchase agreements and securities lending – right of substitution.  If a repurchase agreement at a fixed repurchase price or a price equal to the sale price plus a lender’s return, or a similar securities lending transaction, provides the transferee with a right to substitute assets that are similar and of equal fair value to the transferred asset at the repurchase date, the asset sold or lent under a repurchase or securities lending transaction is not derecognised because the transferor retains substantially all the risks and rewards of ownership.

(d) Repurchase right of first refusal at fair value.  If an entity sells a financial asset and retains only a right of first refusal to repurchase the transferred asset at fair value if the transferee subsequently sells it, the entity derecognises the asset because it has transferred substantially all the risks and rewards of ownership.

(e) Wash sale transaction.  The repurchase of a financial asset shortly after it has been sold is sometimes referred to as a wash sale.  Such a repurchase does not preclude derecognition provided that the original transaction met the derecognition requirements.  However, if an agreement to sell a financial asset is entered into concurrently with an agreement to repurchase the same asset at a fixed price or the sale price plus a lender’s return, then the asset is not derecognised.

(f) Put options and call options that are deeply in the money.  If a transferred financial asset can be called back by the transferor and the call option is deeply in the money, the transfer does not qualify for derecognition because the transferor has retained substantially all the risks and rewards of ownership.  Similarly, if the financial asset can be put back by the transferee and the put option is deeply in the money, the transfer does not qualify for derecognition because the transferor has retained substantially all the risks and rewards of ownership.

(g) Put options and call options that are deeply out of the money.  A financial asset that is transferred subject only to a deep out-of-the-money put option held by the transferee or a deep out-of-the-money call option held by the transferor is derecognised.  This is because the transferor has transferred substantially all the risks and rewards of ownership.

(h) Readily obtainable assets subject to a call option that is neither deeply in the money nor deeply out of the money.  If an entity holds a call option on an asset that is readily obtainable in the market and the option is neither deeply in the money nor deeply out of the money, the asset is derecognised.  This is because the entity (i) has neither retained nor transferred substantially all the risks and rewards of ownership, and (ii) has not retained control.  However, if the asset is not readily obtainable in the market, derecognition is precluded to the extent of the amount of the asset that is subject to the call option because the entity has retained control of the asset. 

(i) A not readily obtainable asset subject to a put option written by an entity that is neither deeply in the money nor deeply out of the money.  If an entity transfers a financial asset that is not readily obtainable in the market, and writes a put option that is not deeply out of the money, the entity neither retains nor transfers substantially all the risks and rewards of ownership because of the written put option.  The entity retains control of the asset if the put option is sufficiently valuable to prevent the transferee from selling the asset, in which case the asset continues to be recognised to the extent of the transferor’s continuing involvement (see paragraph B3.2.9).  The entity transfers control of the asset if the put option is not sufficiently valuable to prevent the transferee from selling the asset, in which case the asset is derecognised.

(j) Assets subject to a fair value put or call option or a forward repurchase agreement.  A transfer of a financial asset that is subject only to a put or call option or a forward repurchase agreement that has an exercise or repurchase price equal to the fair value of the financial asset at the time of repurchase results in derecognition because of the transfer of substantially all the risks and rewards of ownership.

(k) Cash-settled call or put options.  An entity evaluates the transfer of a financial asset that is subject to a put or call option or a forward repurchase agreement that will be settled net in cash to determine whether it has retained or transferred substantially all the risks and rewards of ownership.  If the entity has not retained substantially all the risks and rewards of ownership of the transferred asset, it determines whether it has retained control of the transferred asset.  That the put or the call or the forward repurchase agreement is settled net in cash does not automatically mean that the entity has transferred control (see paragraphs B3.2.9 and (g), (h) and (i) above).

(l) Removal of accounts provision.  A removal of accounts provision is an unconditional repurchase (call) option that gives an entity the right to reclaim assets transferred subject to some restrictions.  Provided that such an option results in the entity neither retaining nor transferring substantially all the risks and rewards of ownership, it precludes derecognition only to the extent of the amount subject to repurchase (assuming that the transferee cannot sell the assets).  For example, if the carrying amount and proceeds from the transfer of loan assets are CU100,000 and any individual loan could be called back but the aggregate amount of loans that could be repurchased could not exceed CU10,000, CU90,000 of the loans would qualify for derecognition.

(m) Clean-up calls.  An entity, which may be a transferor, that services transferred assets may hold a clean-up call to purchase remaining transferred assets when the amount of outstanding assets falls to a specified level at which the cost of servicing those assets becomes burdensome in relation to the benefits of servicing.  Provided that such a clean-up call results in the entity neither retaining nor transferring substantially all the risks and rewards of ownership and the transferee cannot sell the assets, it precludes derecognition only to the extent of the amount of the assets that is subject to the call option.

(n) Subordinated retained interests and credit guarantees.  An entity may provide the transferee with credit enhancement by subordinating some or all of its interest retained in the transferred asset.  Alternatively, an entity may provide the transferee with credit enhancement in the form of a credit guarantee that could be unlimited or limited to a specified amount.  If the entity retains substantially all the risks and rewards of ownership of the transferred asset, the asset continues to be recognised in its entirety.  If the entity retains some, but not substantially all, of the risks and rewards of ownership and has retained control, derecognition is precluded to the extent of the amount of cash or other assets that the entity could be required to pay. 

(o) Total return swaps.  An entity may sell a financial asset to a transferee and enter into a total return swap with the transferee, whereby all of the interest payment cash flows from the underlying asset are remitted to the entity in exchange for a fixed payment or variable rate payment and any increases or declines in the fair value of the underlying asset are absorbed by the entity.  In such a case, derecognition of all of the asset is prohibited.

(p) Interest rate swaps.  An entity may transfer to a transferee a fixed rate financial asset and enter into an interest rate swap with the transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount that is equal to the principal amount of the transferred financial asset.  The interest rate swap does not preclude derecognition of the transferred asset provided the payments on the swap are not conditional on payments being made on the transferred asset.

(q) Amortising interest rate swaps.  An entity may transfer to a transferee a fixed rate financial asset that is paid off over time, and enter into an amortising interest rate swap with the transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount.  If the notional amount of the swap amortises so that it equals the principal amount of the transferred financial asset outstanding at any point in time, the swap would generally result in the entity retaining substantial prepayment risk, in which case the entity either continues to recognise all of the transferred asset or continues to recognise the transferred asset to the extent of its continuing involvement.  Conversely, if the amortisation of the notional amount of the swap is not linked to the principal amount outstanding of the transferred asset, such a swap would not result in the entity retaining prepayment risk on the asset.  Hence, it would not preclude derecognition of the transferred asset provided the payments on the swap are not conditional on interest payments being made on the transferred asset and the swap does not result in the entity retaining any other significant risks and rewards of ownership on the transferred asset.

B3.2.17 This paragraph illustrates the application of the continuing involvement approach when the entity’s continuing involvement is in a part of a financial asset.

Derecognition of financial liabilities (section 3.3)

B3.3.1 A financial liability (or part of it) is extinguished when the debtor either:

(a) discharges the liability (or part of it) by paying the creditor, normally with cash, other financial assets, goods or services; or

(b) is legally released from primary responsibility for the liability (or part of it) either by process of law or by the creditor.  (If the debtor has given a guarantee this condition may still be met.)

B3.3.2 If an issuer of a debt instrument repurchases that instrument, the debt is extinguished even if the issuer is a market maker in that instrument or intends to resell it in the near term.

B3.3.3 Payment to a third party, including a trust (sometimes called ‘in-substance defeasance’), does not, by itself, relieve the debtor of its primary obligation to the creditor, in the absence of legal release.

B3.3.4 If a debtor pays a third party to assume an obligation and notifies its creditor that the third party has assumed its debt obligation, the debtor does not derecognise the debt obligation unless the condition in paragraph B3.3.1(b) is met.  If the debtor pays a third party to assume an obligation and obtains a legal release from its creditor, the debtor has extinguished the debt.  However, if the debtor agrees to make payments on the debt to the third party or direct to its original creditor, the debtor recognises a new debt obligation to the third party.

B3.3.5 Although legal release, whether judicially or by the creditor, results in derecognition of a liability, the entity may recognise a new liability if the derecognition criteria in paragraphs 3.2.1-3.2.23 are not met for the financial assets transferred.  If those criteria are not met, the transferred assets are not derecognised, and the entity recognises a new liability relating to the transferred assets.

B3.3.6 For the purpose of paragraph 3.3.2, the terms are substantially different if the discounted 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, is at least 10 per cent different from the discounted present value of the remaining cash flows of the original financial liability.  If an exchange of debt instruments or modification of terms is accounted for as an extinguishment, any costs or fees incurred are recognised as part of the gain or loss on the extinguishment.  If the exchange or modification is not accounted for as an extinguishment, any costs or fees incurred adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability.

B3.3.7 In some cases, a creditor releases a debtor from its present obligation to make payments, but the debtor assumes a guarantee obligation to pay if the party assuming primary responsibility defaults.  In these circumstances the debtor:

(a) recognises a new financial liability based on the fair value of its obligation for the guarantee, and

(b) recognises a gain or loss based on the difference between (i) any proceeds paid and (ii) the carrying amount of the original financial liability less the fair value of the new financial liability.

Classification (chapter 4)

Classification of financial assets (section 4.1)

The entity’s business model for managing financial assets

B4.1.1 Paragraph 4.1.1(a) requires an entity to classify financial assets as subsequently measured at amortised cost or fair value on the basis of the entity’s business model for managing the financial assets.  An entity assesses whether its financial assets meet this condition on the basis of the objective of the business model as determined by the entity’s key management personnel (as defined in AASB 124). 

B4.1.2 The entity’s business model does not depend on management’s intentions for an individual instrument.  Accordingly, this condition is not an instrument-by-instrument approach to classification and should be determined on a higher level of aggregation.  However, a single entity may have more than one business model for managing its financial instruments.  Therefore, classification need not be determined at the reporting entity level.  For example, an entity may hold a portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to trade to realise fair value changes. 

B4.1.3 Although the objective of an entity’s business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity.  Thus an entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur.  For example, the entity may sell a financial asset if:

(a) the financial asset no longer meets the entity’s investment policy (eg the credit rating of the asset declines below that required by the entity’s investment policy);

(b) an insurer adjusts its investment portfolio to reflect a change in expected duration (ie the expected timing of payouts); or

(c) an entity needs to fund capital expenditures.

However, if more than an infrequent number of sales are made out of a portfolio, the entity needs to assess whether and how such sales are consistent with an objective of collecting contractual cash flows.

B4.1.4 The following are examples of when the objective of an entity’s business model may be to hold financial assets to collect the contractual cash flows.  This list of examples is not exhaustive.

B4.1.5 One business model in which the objective is not to hold instruments to collect the contractual cash flows is if an entity manages the performance of a portfolio of financial assets with the objective of realising cash flows through the sale of the assets.  For example, if an entity actively manages a portfolio of assets in order to realise fair value changes arising from changes in credit spreads and yield curves, its business model is not to hold those assets to collect the contractual cash flows.  The entity’s objective results in active buying and selling and the entity is managing the instruments to realise fair value gains rather than to collect the contractual cash flows. 

B4.1.6 A portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis (as described in paragraph 4.2.2(b)) is not held to collect contractual cash flows.  Also, a portfolio of financial assets that meets the definition of held for trading is not held to collect contractual cash flows.  Such portfolios of instruments must be measured at fair value through profit or loss.

Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding

B4.1.7 Paragraph 4.1.1 requires an entity (unless paragraph 4.1.5 applies) to classify a financial asset as subsequently measured at amortised cost or fair value on the basis of the contractual cash flow characteristics of the financial asset that is in a group of financial assets managed for the collection of the contractual cash flows.

B4.1.8 An entity shall assess whether contractual cash flows are solely payments of principal and interest on the principal amount outstanding for the currency in which the financial asset is denominated (see also paragraph B5.7.2).

B4.1.9 Leverage is a contractual cash flow characteristic of some financial assets.  Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest.  Stand-alone option, forward and swap contracts are examples of financial assets that include leverage.  Thus such contracts do not meet the condition in paragraph 4.1.2(b) and cannot be subsequently measured at amortised cost.

B4.1.10 Contractual provisions that permit the issuer (ie the debtor) to prepay a debt instrument (eg a loan or a bond) or permit the holder (ie the creditor) to put a debt instrument back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(a) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or

(ii) the holder or issuer against changes in relevant taxation or law; and

(b) the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the early termination of the contract.

B4.1.11 Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument (ie an extension option) result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(a) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations) or a change in control of the issuer; or

(ii) the holder or issuer against changes in relevant taxation or law; and

(b) the terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding.

B4.1.12 A contractual term that changes the timing or amount of payments of principal or interest does not result in contractual cash flows that are solely principal and interest on the principal amount outstanding unless it:

(a) is a variable interest rate that is consideration for the time value of money and the credit risk (which may be determined at initial recognition only, and so may be fixed) associated with the principal amount outstanding; and

(b) if the contractual term is a prepayment option, meets the conditions in paragraph B4.1.10; or

(c) if the contractual term is an extension option, meets the conditions in paragraph B4.1.11.

B4.1.13 The following examples illustrate contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.  This list of examples is not exhaustive.

B4.1.14 The following examples illustrate contractual cash flows that are not payments of principal and interest on the principal amount outstanding.  This list of examples is not exhaustive.

B4.1.15 In some cases a financial asset may have contractual cash flows that are described as principal and interest but those cash flows do not represent the payment of principal and interest on the principal amount outstanding as described in paragraphs 4.1.2(b) and 4.1.3 of this Standard.

B4.1.16 This may be the case if the financial asset represents an investment in particular assets or cash flows and hence the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding.  For example, the contractual cash flows may include payment for factors other than consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.  As a result, the instrument would not satisfy the condition in paragraph 4.1.2(b).  This could be the case when a creditor’s claim is limited to specified assets of the debtor or the cash flows from specified assets (for example, a ‘non-recourse’ financial asset).

B4.1.17 However, the fact that a financial asset is non-recourse does not in itself necessarily preclude the financial asset from meeting the condition in paragraph 4.1.2(b).  In such situations, the creditor is required to assess (‘look through to’) the particular underlying assets or cash flows to determine whether the contractual cash flows of the financial asset being classified are payments of principal and interest on the principal amount outstanding.  If the terms of the financial asset give rise to any other cash flows or limit the cash flows in a manner inconsistent with payments representing principal and interest, the financial asset does not meet the condition in paragraph 4.1.2(b).  Whether the underlying assets are financial assets or non-financial assets does not in itself affect this assessment. 

B4.1.18 If a contractual cash flow characteristic is not genuine, it does not affect the classification of a financial asset.  A cash flow characteristic is not genuine if it affects the instrument’s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur.

B4.1.19 In almost every lending transaction the creditor’s instrument is ranked relative to the instruments of the debtor’s other creditors.  An instrument that is subordinated to other instruments may have contractual cash flows that are payments of principal and interest on the principal amount outstanding if the debtor’s non-payment is a breach of contract and the holder has a contractual right to unpaid amounts of principal and interest on the principal amount outstanding even in the event of the debtor’s bankruptcy.  For example, a trade receivable that ranks its creditor as a general creditor would qualify as having payments of principal and interest on the principal amount outstanding.  This is the case even if the debtor issued loans that are collateralised, which in the event of bankruptcy would give that loan holder priority over the claims of the general creditor in respect of the collateral but does not affect the contractual right of the general creditor to unpaid principal and other amounts due.

Contractually linked instruments

B4.1.20 In some types of transactions, an entity may prioritise payments to the holders of financial assets using multiple contractually linked instruments that create concentrations of credit risk (tranches).  Each tranche has a subordination ranking that specifies the order in which any cash flows generated by the issuer are allocated to the tranche.  In such situations, the holders of a tranche have the right to payments of principal and interest on the principal amount outstanding only if the issuer generates sufficient cash flows to satisfy higher-ranking tranches.

B4.1.21 In such transactions, a tranche has cash flow characteristics that are payments of principal and interest on the principal amount outstanding only if:

(a) the contractual terms of the tranche being assessed for classification (without looking through to the underlying pool of financial instruments) give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (eg the interest rate on the tranche is not linked to a commodity index);

(b) the underlying pool of financial instruments has the cash flow characteristics set out in paragraphs B4.1.23 and B4.1.24; and

(c) the exposure to credit risk in the underlying pool of financial instruments inherent in the tranche is equal to or lower than the exposure to credit risk of the underlying pool of financial instruments (for example, this condition would be met if the underlying pool of instruments were to lose 50 per cent as a result of credit losses and under all circumstances the tranche would lose 50 per cent or less).

B4.1.22 An entity must look through until it can identify the underlying pool of instruments that are creating (rather than passing through) the cash flows.  This is the underlying pool of financial instruments. 

B4.1.23 The underlying pool must contain one or more instruments that have contractual cash flows that are solely payments of principal and interest on the principal amount outstanding. 

B4.1.24 The underlying pool of instruments may also include instruments that:

(a) reduce the cash flow variability of the instruments in paragraph B4.1.23 and, when combined with the instruments in paragraph B4.1.23, result in cash flows that are solely payments of principal and interest on the principal amount outstanding (eg an interest rate cap or floor or a contract that reduces the credit risk on some or all of the instruments in paragraph B4.1.23); or

(b) align the cash flows of the tranches with the cash flows of the pool of underlying instruments in paragraph B4.1.23 to address differences in and only in:

(i) whether the interest rate is fixed or floating;

(ii) the currency in which the cash flows are denominated, including inflation in that currency; or

(iii) the timing of the cash flows.

B4.1.25 If any instrument in the pool does not meet the conditions in either paragraph B4.1.23 or paragraph B4.1.24, the condition in paragraph B4.1.21(b) is not met. 

B4.1.26 If the holder cannot assess the conditions in paragraph B4.1.21 at initial recognition, the tranche must be measured at fair value.  If the underlying pool of instruments can change after initial recognition in such a way that the pool may not meet the conditions in paragraphs B4.1.23 and B4.1.24, the tranche does not meet the conditions in paragraph B4.1.21 and must be measured at fair value.

Option to designate a financial asset or financial liability as at fair value through profit or loss (sections 4.1 and 4.2)

B4.1.27 Subject to the conditions in paragraphs 4.1.5 and 4.2.2, this Standard allows an entity to designate a financial asset, a financial liability, or a group of financial instruments (financial assets, financial liabilities or both) as at fair value through profit or loss provided that doing so results in more relevant information.

B4.1.28 The decision of an entity to designate a financial asset or financial liability as at fair value through profit or loss is similar to an accounting policy choice (although, unlike an accounting policy choice, it is not required to be applied consistently to all similar transactions).  When an entity has such a choice, paragraph 14(b) of AASB 108 requires the chosen policy to result in the financial statements providing reliable and more relevant information about the effects of transactions, other events and conditions on the entity’s financial position, financial performance or cash flows.  For example, in the case of designation of a financial liability as at fair value through profit or loss, paragraph 4.2.2 sets out the two circumstances when the requirement for more relevant information will be met.  Accordingly, to choose such designation in accordance with paragraph 4.2.2, the entity needs to demonstrate that it falls within one (or both) of these two circumstances.

Designation eliminates or significantly reduces an accounting mismatch

B4.1.29 Measurement of a financial asset or financial liability and classification of recognised changes in its value are determined by the item’s classification and whether the item is part of a designated hedging relationship.  Those requirements can create a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’) when, for example, in the absence of designation as at fair value through profit or loss, a financial asset would be classified as subsequently measured at fair value and a liability the entity considers related would be subsequently measured at amortised cost (with changes in fair value not recognised).  In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were measured as at fair value through profit or loss.

B4.1.30 The following examples show when this condition could be met.  In all cases, an entity may use this condition to designate financial assets or financial liabilities as at fair value through profit or loss only if it meets the principle in paragraph 4.1.5 or 4.2.2(a):

(a) an entity has liabilities under insurance contracts whose measurement incorporates current information (as permitted by paragraph 24 of AASB 4) and financial assets that it considers to be related and that would otherwise be measured at amortised cost.

(b) an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, and that gives rise to opposite changes in fair value that tend to offset each other.  However, only some of the instruments would be measured at fair value through profit or loss (for example, those that are derivatives, or are classified as held for trading).  It may also be the case that the requirements for hedge accounting are not met because, for example, the requirements for hedge effectiveness in paragraph 6.4.1 are not met.

(c) an entity has financial assets, financial liabilities or both that share a risk, such as interest rate risk, that gives rise to opposite changes in fair value that tend to offset each other and none of the financial assets or financial liabilities qualifies for designation as a hedging instrument because they are not measured at fair value through profit or loss.  Furthermore, in the absence of hedge accounting there is a significant inconsistency in the recognition of gains and losses.  For example, the entity has financed a specified group of loans by issuing traded bonds whose changes in fair value tend to offset each other.  If, in addition, the entity regularly buys and sells the bonds but rarely, if ever, buys and sells the loans, reporting both the loans and the bonds at fair value through profit or loss eliminates the inconsistency in the timing of the recognition of the gains and losses that would otherwise result from measuring them both at amortised cost and recognising a gain or loss each time a bond is repurchased.

B4.1.31 In cases such as those described in the preceding paragraph, to designate, at initial recognition, the financial assets and financial liabilities not otherwise so measured as at fair value through profit or loss may eliminate or significantly reduce the measurement or recognition inconsistency and produce more relevant information.  For practical purposes, the entity need not enter into all of the assets and liabilities giving rise to the measurement or recognition inconsistency at exactly the same time.  A reasonable delay is permitted provided that each transaction is designated as at fair value through profit or loss at its initial recognition and, at that time, any remaining transactions are expected to occur.

B4.1.32 It would not be acceptable to designate only some of the financial assets and financial liabilities giving rise to the inconsistency as at fair value through profit or loss if to do so would not eliminate or significantly reduce the inconsistency and would therefore not result in more relevant information.  However, it would be acceptable to designate only some of a number of similar financial assets or similar financial liabilities if doing so achieves a significant reduction (and possibly a greater reduction than other allowable designations) in the inconsistency.  For example, assume an entity has a number of similar financial liabilities that sum to CU100 and a number of similar financial assets that sum to CU50 but are measured on a different basis.  The entity may significantly reduce the measurement inconsistency by designating at initial recognition all of the assets but only some of the liabilities (for example, individual liabilities with a combined total of CU45) as at fair value through profit or loss.  However, because designation as at fair value through profit or loss can be applied only to the whole of a financial instrument, the entity in this example must designate one or more liabilities in their entirety.  It could not designate either a component of a liability (eg changes in value attributable to only one risk, such as changes in a benchmark interest rate) or a proportion (ie percentage) of a liability.

A group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis

B4.1.33 An entity may manage and evaluate the performance of a group of financial liabilities or financial assets and financial liabilities in such a way that measuring that group at fair value through profit or loss results in more relevant information.  The focus in this instance is on the way the entity manages and evaluates performance, rather than on the nature of its financial instruments.

B4.1.34 For example, an entity may use this condition to designate financial liabilities as at fair value through profit or loss if it meets the principle in paragraph 4.2.2(b) and the entity has financial assets and financial liabilities that share one or more risks and those risks are managed and evaluated on a fair value basis in accordance with a documented policy of asset and liability management.  An example could be an entity that has issued ‘structured products’ containing multiple embedded derivatives and manages the resulting risks on a fair value basis using a mix of derivative and non-derivative financial instruments. 

B4.1.35 As noted above, this condition relies on the way the entity manages and evaluates performance of the group of financial instruments under consideration.  Accordingly, (subject to the requirement of designation at initial recognition) an entity that designates financial liabilities as at fair value through profit or loss on the basis of this condition shall so designate all eligible financial liabilities that are managed and evaluated together. 

B4.1.36 Documentation of the entity’s strategy need not be extensive but should be sufficient to demonstrate compliance with paragraph 4.2.2(b).  Such documentation is not required for each individual item, but may be on a portfolio basis.  For example, if the performance management system for a department – as approved by the entity’s key management personnel – clearly demonstrates that its performance is evaluated on a total return basis, no further documentation is required to demonstrate compliance with paragraph 4.2.2(b).

Embedded derivatives (section 4.3)

B4.3.1 When an entity becomes a party to a hybrid contract with a host that is not an asset within the scope of this Standard, paragraph 4.3.3 requires the entity to identify any embedded derivative, assess whether it is required to be separated from the host contract and, for those that are required to be separated, measure the derivatives at fair value at initial recognition and subsequently. 

B4.3.2 If a host contract has no stated or predetermined maturity and represents a residual interest in the net assets of an entity, then its economic characteristics and risks are those of an equity instrument, and an embedded derivative would need to possess equity characteristics related to the same entity to be regarded as closely related.  If the host contract is not an equity instrument and meets the definition of a financial instrument, then its economic characteristics and risks are those of a debt instrument.

B4.3.3 An embedded non-option derivative (such as an embedded forward or swap) is separated from its host contract on the basis of its stated or implied substantive terms, so as to result in it having a fair value of zero at initial recognition.  An embedded option-based derivative (such as an embedded put, call, cap, floor or swaption) is separated from its host contract on the basis of the stated terms of the option feature.  The initial carrying amount of the host instrument is the residual amount after separating the embedded derivative.

B4.3.4 Generally, multiple embedded derivatives in a single hybrid contract are treated as a single compound embedded derivative.  However, embedded derivatives that are classified as equity (see AASB 132) are accounted for separately from those classified as assets or liabilities.  In addition, if a hybrid contract has more than one embedded derivative and those derivatives relate to different risk exposures and are readily separable and independent of each other, they are accounted for separately from each other.

B4.3.5 The economic characteristics and risks of an embedded derivative are not closely related to the host contract (paragraph 4.3.3(a)) in the following examples.  In these examples, assuming the conditions in paragraph 4.3.3(b) and (c) are met, an entity accounts for the embedded derivative separately from the host contract.

(a) A put option embedded in an instrument that enables the holder to require the issuer to reacquire the instrument for an amount of cash or other assets that varies on the basis of the change in an equity or commodity price or index is not closely related to a host debt instrument.

(b) 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.  If an entity issues a debt instrument and the holder of that debt instrument writes a call option on the debt instrument to a third party, the issuer regards the call option as extending the term to maturity of the debt instrument provided the issuer can be required to participate in or facilitate the remarketing of the debt instrument as a result of the call option being exercised.

(c) Equity-indexed interest or principal payments embedded in a host debt instrument or insurance contract – by which the amount of interest or principal is indexed to the value of equity instruments – are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar.

(d) Commodity-indexed interest or principal payments embedded in a host debt instrument or insurance contract – by which the amount of interest or principal is indexed to the price of a commodity (such as gold) – are not closely related to the host instrument because the risks inherent in the host and the embedded derivative are dissimilar.

(e) A call, put, or prepayment option embedded in a host debt contract or host insurance contract is not closely related to the host contract unless:

(i) the option’s exercise price 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; or

(ii) the exercise price of a 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 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. 

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 a convertible debt instrument in accordance with AASB 132.

(f) Credit derivatives that are embedded in a host debt instrument and allow one party (the ‘beneficiary’) to transfer the credit risk of a particular reference asset, which it may not own, to another party (the ‘guarantor’) are not closely related to the host debt instrument.  Such credit derivatives allow the guarantor to assume the credit risk associated with the reference asset without directly owning it.

B4.3.6 An example of a hybrid contract is a financial instrument that gives the holder a right to put the financial instrument back to the issuer in exchange for an amount of cash or other financial assets that varies on the basis of the change in an equity or commodity index that may increase or decrease (a ‘puttable instrument’).  Unless the issuer on initial recognition designates the puttable instrument as a financial liability at fair value through profit or loss, it is required to separate an embedded derivative (ie the indexed principal payment) under paragraph 4.3.3 because the host contract is a debt instrument under paragraph B4.3.2 and the indexed principal payment is not closely related to a host debt instrument under paragraph B4.3.5(a).  Because the principal payment can increase and decrease, the embedded derivative is a non-option derivative whose value is indexed to the underlying variable.

B4.3.7 In the case of a puttable instrument that can be put back at any time for cash equal to a proportionate share of the net asset value of an entity (such as units of an open-ended mutual fund or some unit-linked investment products), the effect of separating an embedded derivative and accounting for each component is to measure the hybrid contract at the redemption amount that is payable at the end of the reporting period if the holder exercised its right to put the instrument back to the issuer.

B4.3.8 The economic characteristics and risks of an embedded derivative are closely related to the economic characteristics and risks of the host contract in the following examples.  In these examples, an entity does not account for the embedded derivative separately from the host contract.

(a) An embedded derivative in which the underlying is an interest rate or interest rate 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 is closely related to the host contract unless the hybrid contract can be settled in such a way that the holder would not recover substantially all of its recognised investment or the embedded derivative could at least double the holder’s initial rate of return on the host contract 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.

(b) An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, provided 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.  Similarly, provisions included in a contract to purchase or sell an asset (eg a commodity) that establish a cap and a floor on the price to be paid or received for the asset are closely related to the host contract if both the cap and floor were out of the money at inception and are not leveraged.

(c) An embedded foreign currency derivative that provides a stream of principal or interest payments that are denominated in a foreign currency and is embedded in a host debt instrument (for example, a dual currency bond) is closely related to the host debt instrument.  Such a derivative is not separated from the host instrument because AASB 121 The Effects of Changes in Foreign Exchange Rates requires foreign currency gains and losses on monetary items to be recognised in profit or loss.

(d) An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:

(i) the functional currency of any substantial party to that contract;

(ii) the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or

(iii) a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).

(e) An embedded prepayment option in an interest-only or principal-only strip is closely related to the host contract provided the host contract (i) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative, and (ii) does not contain any terms not present in the original host debt contract.

(f) An embedded derivative in a host lease contract is closely related to the host contract if the embedded derivative is (i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the entity’s own economic environment), (ii) contingent rentals based on related sales or (iii) contingent rentals based on variable interest rates.

(g) A unit-linking feature embedded in a host financial instrument or host insurance contract is closely related to the host instrument or host contract if the unit-denominated payments are measured at current unit values that reflect the fair values of the assets of the fund.  A unit-linking feature is a contractual term that requires payments denominated in units of an internal or external investment fund.

(h) A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract).

Instruments containing embedded derivatives

B4.3.9 As noted in paragraph B4.3.1, when an entity becomes a party to a hybrid contract with a host that is not an asset within the scope of this Standard and with one or more embedded derivatives, paragraph 4.3.3 requires the entity to identify any such embedded derivative, assess whether it is required to be separated from the host contract and, for those that are required to be separated, measure the derivatives at fair value at initial recognition and subsequently.  These requirements can be more complex, or result in less reliable measures, than measuring the entire instrument at fair value through profit or loss.  For that reason this Standard permits the entire hybrid contract to be designated as at fair value through profit or loss.

B4.3.10 Such designation may be used whether paragraph 4.3.3 requires the embedded derivatives to be separated from the host contract or prohibits such separation.  However, paragraph 4.3.5 would not justify designating the hybrid contract as at fair value through profit or loss in the cases set out in paragraph 4.3.5(a) and (b) because doing so would not reduce complexity or increase reliability. 

Reassessment of embedded derivatives

B4.3.11 In accordance with paragraph 4.3.3, an entity shall assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative 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 otherwise would be required under the contract, in which case reassessment is required.  An entity determines whether a modification to cash flows is significant by considering the extent to which the expected future cash flows associated with the embedded derivative, the host contract or both have changed and whether the change is significant relative to the previously expected cash flows on the contract.

B4.3.12 Paragraph B4.3.11 does not apply to embedded derivatives in contracts acquired in:

(a) a business combination (as defined in AASB 3 Business Combinations);

(b) a combination of entities or businesses under common control as described in paragraphs B1-B4 of AASB 3; or

(c) the formation of a joint venture as defined in AASB 11 Joint Arrangements

or their possible reassessment at the date of acquisition.[1]

Reclassification of financial assets (section 4.4)

B4.4.1 Paragraph 4.4.1 requires an entity to reclassify financial assets if the objective of the entity’s business model for managing those financial assets changes.  Such changes are expected to be very infrequent.  Such changes must be determined by the entity’s senior management as a result of external or internal changes and must be significant to the entity’s operations and demonstrable to external parties.  Examples of a change in business model include the following:

(a) An entity has a portfolio of commercial loans that it holds to sell in the short-term.  The entity acquires a company that manages commercial loans and has a business model that holds the loans in order to collect the contractual cash flows.  The portfolio of commercial loans is no longer for sale, and the portfolio is now managed together with the acquired commercial loans and all are held to collect the contractual cash flows. 

(b) A financial services firm decides to shut down its retail mortgage business.  That business no longer accepts new business and the financial services firm is actively marketing its mortgage loan portfolio for sale. 

B4.4.2 A change in the objective of the entity’s business model must be effected before the reclassification date.  For example, if a financial services firm decides on 15 February to shut down its retail mortgage business and hence must reclassify all affected financial assets on 1 April (ie the first day of the entity’s next reporting period), the entity must not accept new retail mortgage business or otherwise engage in activities consistent with its former business model after 15 February. 

B4.4.3 The following are not changes in business model:

(a) A change in intention related to particular financial assets (even in circumstances of significant changes in market conditions). 

(b) The temporary disappearance of a particular market for financial assets. 

(c) A transfer of financial assets between parts of the entity with different business models.

Measurement (chapter 5)

Initial measurement (section 5.1)

B5.1.1 The fair value of a financial instrument at initial recognition is normally the transaction price (ie the fair value of the consideration given or received, see also paragraph B5.1.2A and AASB 13).  However, if part of the consideration given or received is for something other than the financial instrument, an entity shall measure the fair value of the financial instrument.  For example, the fair value of a long-term loan or receivable that carries no interest can be measured as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating.  Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.

B5.1.2 If an entity originates a loan that bears an off-market interest rate (eg 5 per cent when the market rate for similar loans is 8 per cent), and receives an upfront fee as compensation, the entity recognises the loan at its fair value, ie net of the fee it receives.

B5.1.2A The best evidence of the fair value of a financial instrument at initial recognition is normally the transaction price (ie the fair value of the consideration given or received, see also AASB 13).  If an entity determines that the fair value at initial recognition differs from the transaction price as mentioned in paragraph 5.1.1A, the entity shall account for that instrument at that date as follows:

(a)          at the measurement required by paragraph 5.1.1 if that fair value is evidenced by a quoted price in an active market for an identical asset or liability (ie a Level 1 input) or based on a valuation technique that uses only data from observable markets.  An entity shall recognise the difference between the fair value at initial recognition and the transaction price as a gain or loss.

(b)         in all other cases, at the measurement required by paragraph 5.1.1, adjusted to defer the difference between the fair value at initial recognition and the transaction price.  After initial recognition, the entity shall recognise that deferred difference as a gain or loss only to the extent that it arises from a change in a factor (including time) that market participants would take into account when pricing the asset or liability.

Subsequent measurement of financial assets (section 5.2)

B5.2.1 If a financial instrument that was previously recognised as a financial asset is measured at fair value and its fair value decreases below zero, it is a financial liability measured in accordance with paragraph 4.2.1.  However, hybrid contracts with hosts that are assets within the scope of this Standard are always measured in accordance with paragraph 4.3.2.

B5.2.2 The following example illustrates the accounting for transaction costs on the initial and subsequent measurement of a financial asset measured at fair value with changes through other comprehensive income in accordance with paragraph 5.7.5.  An entity acquires an asset for CU100 plus a purchase commission of CU2.  Initially, the entity recognises the asset at CU102.  The reporting period ends one day later, when the quoted market price of the asset is CU100.  If the asset were sold, a commission of CU3 would be paid.  On that date, the entity measures the asset at CU100 (without regard to the possible commission on sale) and recognises a loss of CU2 in other comprehensive income.

B5.2.2A The subsequent measurement of a financial asset or financial liability and the subsequent recognition of gains and losses described in paragraph B5.1.2A shall be consistent with the requirements of this Standard.

B5.4.1-B5.4.13 [Deleted by the IASB]

Investments in equity instruments and contracts on those investments

B5.4.14 All investments in equity instruments and contracts on those instruments must be measured at fair value.  However, in limited circumstances, cost may be an appropriate estimate of fair value.  That may be the case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range.

B5.4.15 Indicators that cost might not be representative of fair value include:

(a) a significant change in the performance of the investee compared with budgets, plans or milestones.

(b) changes in expectation that the investee’s technical product milestones will be achieved.

(c) a significant change in the market for the investee’s equity or its products or potential products.

(d) a significant change in the global economy or the economic environment in which the investee operates.

(e) a significant change in the performance of comparable entities, or in the valuations implied by the overall market.

(f) internal matters of the investee such as fraud, commercial disputes, litigation, changes in management or strategy.

(g) evidence from external transactions in the investee’s equity, either by the investee (such as a fresh issue of equity), or by transfers of equity instruments between third parties.

B5.4.16 The list in paragraph B5.4.15 is not exhaustive.  An entity shall use all information about the performance and operations of the investee that becomes available after the date of initial recognition.  To the extent that any such relevant factors exist, they may indicate that cost might not be representative of fair value.  In such cases, the entity must measure fair value.

B5.4.17 Cost is never the best estimate of fair value for investments in quoted equity instruments (or contracts on quoted equity instruments).

Gains and losses (section 5.7)

B5.7.1 Paragraph 5.7.5 permits an entity to make an irrevocable election to present in other comprehensive income changes in the fair value of an investment in an equity instrument that is not held for trading.  This election is made on an instrument-by-instrument (ie share-by-share) basis.  Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss.  However, the entity may transfer the cumulative gain or loss within equity.  Dividends on such investments are recognised in profit or loss in accordance with paragraph 5.7.6 unless the dividend clearly represents a recovery of part of the cost of the investment.

B5.7.2 An entity applies AASB 121 to financial assets and financial liabilities that are monetary items in accordance with AASB 121 and denominated in a foreign currency.  AASB 121 requires any foreign exchange gains and losses on monetary assets and monetary liabilities to be recognised in profit or loss.  An exception is a monetary item that is designated as a hedging instrument in a cash flow hedge (see paragraph 6.5.11), a hedge of a net investment (see paragraph 6.5.13) or a fair value hedge of an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income in accordance with paragraph 5.7.5 (see paragraph 6.5.8).

B5.7.3 Paragraph 5.7.5 permits an entity to make an irrevocable election to present in other comprehensive income changes in the fair value of an investment in an equity instrument that is not held for trading.  Such an investment is not a monetary item.  Accordingly, the gain or loss that is presented in other comprehensive income in accordance with paragraph 5.7.5 includes any related foreign exchange component.

B5.7.4 If there is a hedging relationship between a non-derivative monetary asset and a non-derivative monetary liability, changes in the foreign currency component of those financial instruments are presented in profit or loss.

Liabilities designated as at fair value through profit or loss

B5.7.5 When an entity designates a financial liability as at fair value through profit or loss, it must determine whether presenting in other comprehensive income the effects of changes in the liability’s credit risk would create or enlarge an accounting mismatch in profit or loss.  An accounting mismatch would be created or enlarged if presenting the effects of changes in the liability’s credit risk in other comprehensive income would result in a greater mismatch in profit or loss than if those amounts were presented in profit or loss.

B5.7.6 To make that determination, an entity must assess whether it expects that the effects of changes in the liability’s credit risk will be offset in profit or loss by a change in the fair value of another financial instrument measured at fair value through profit or loss.  Such an expectation must be based on an economic relationship between the characteristics of the liability and the characteristics of the other financial instrument. 

B5.7.7 That determination is made at initial recognition and is not reassessed.  For practical purposes the entity need not enter into all of the assets and liabilities giving rise to an accounting mismatch at exactly the same time.  A reasonable delay is permitted provided that any remaining transactions are expected to occur.  An entity must apply consistently its methodology for determining whether presenting in other comprehensive income the effects of changes in the liability’s credit risk would create or enlarge an accounting mismatch in profit or loss.  However, an entity may use different methodologies when there are different economic relationships between the characteristics of the liabilities designated as at fair value through profit or loss and the characteristics of the other financial instruments.  AASB 7 requires an entity to provide qualitative disclosures in the notes to the financial statements about its methodology for making that determination. 

B5.7.8 If such a mismatch would be created or enlarged, the entity is required to present all changes in fair value (including the effects of changes in the credit risk of the liability) in profit or loss.  If such a mismatch would not be created or enlarged, the entity is required to present the effects of changes in the liability’s credit risk in other comprehensive income. 

B5.7.9 Amounts presented in other comprehensive income shall not be subsequently transferred to profit or loss.  However, the entity may transfer the cumulative gain or loss within equity.

B5.7.10 The following example describes a situation in which an accounting mismatch would be created in profit or loss if the effects of changes in the credit risk of the liability were presented in other comprehensive income.  A mortgage bank provides loans to customers and funds those loans by selling bonds with matching characteristics (eg amount outstanding, repayment profile, term and currency) in the market.  The contractual terms of the loan permit the mortgage customer to prepay its loan (ie satisfy its obligation to the bank) by buying the corresponding bond at fair value in the market and delivering that bond to the mortgage bank.  As a result of that contractual prepayment right, if the credit quality of the bond worsens (and, thus, the fair value of the mortgage bank’s liability decreases), the fair value of the mortgage bank’s loan asset also decreases.  The change in the fair value of the asset reflects the mortgage customer’s contractual right to prepay the mortgage loan by buying the underlying bond at fair value (which, in this example, has decreased) and delivering the bond to the mortgage bank.  Therefore, the effects of changes in the credit risk of the liability (the bond) will be offset in profit or loss by a corresponding change in the fair value of a financial asset (the loan).  If the effects of changes in the liability’s credit risk were presented in other comprehensive income there would be an accounting mismatch in profit or loss.  Therefore, the mortgage bank is required to present all changes in fair value of the liability (including the effects of changes in the liability’s credit risk) in profit or loss.

B5.7.11 In the example in paragraph B5.7.10, there is a contractual linkage between the effects of changes in the credit risk of the liability and changes in the fair value of the financial asset (ie as a result of the mortgage customer’s contractual right to prepay the loan by buying the bond at fair value and delivering the bond to the mortgage bank).  However, an accounting mismatch may also occur in the absence of a contractual linkage.

B5.7.12 For the purposes of applying the requirements in paragraphs 5.7.7 and 5.7.8, an accounting mismatch is not caused solely by the measurement method that an entity uses to determine the effects of changes in a liability’s credit risk.  An accounting mismatch in profit or loss would arise only when the effects of changes in the liability’s credit risk (as defined in AASB 7) are expected to be offset by changes in the fair value of another financial instrument.  A mismatch that arises solely as a result of the measurement method (ie because an entity does not isolate changes in a liability’s credit risk from some other changes in its fair value) does not affect the determination required by paragraphs 5.7.7 and 5.7.8.  For example, an entity may not isolate changes in a liability’s credit risk from changes in liquidity risk.  If the entity presents the combined effect of both factors in other comprehensive income, a mismatch may occur because changes in liquidity risk may be included in the fair value measurement of the entity’s financial assets and the entire fair value change of those assets is presented in profit or loss.  However, such a mismatch is caused by measurement imprecision, not the offsetting relationship described in paragraph B5.7.6 and, therefore, does not affect the determination required by paragraphs 5.7.7 and 5.7.8.

The meaning of ‘credit risk’

B5.7.13 AASB 7 defines credit risk as ‘the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation’.  The requirement in paragraph 5.7.7(a) relates to the risk that the issuer will fail to perform on that particular liability.  It does not necessarily relate to the creditworthiness of the issuer.  For example, if an entity issues a collateralised liability and a non-collateralised liability that are otherwise identical, the credit risk of those two liabilities will be different, even though they are issued by the same entity.  The credit risk on the collateralised liability will be less than the credit risk of the non-collateralised liability.  The credit risk for a collateralised liability may be close to zero.

B5.7.14 For the purposes of applying the requirement in paragraph 5.7.7(a), credit risk is different from asset-specific performance risk.  Asset-specific performance risk is not related to the risk that an entity will fail to discharge a particular obligation but rather it is related to the risk that a single asset or a group of assets will perform poorly (or not at all). 

B5.7.15 The following are examples of asset-specific performance risk:

(a) A liability with a unit-linking feature whereby the amount due to investors is contractually determined on the basis of the performance of specified assets.  The effect of that unit-linking feature on the fair value of the liability is asset-specific performance risk, not credit risk.

(b) A liability issued by a structured entity with the following characteristics.  The entity is legally isolated so the assets in the entity are ring-fenced solely for the benefit of its investors, even in the event of bankruptcy.  The entity enters into no other transactions and the assets in the entity cannot be hypothecated.  Amounts are due to the entity’s investors only if the ring-fenced assets generate cash flows.  Thus, changes in the fair value of the liability primarily reflect changes in the fair value of the assets.  The effect of the performance of the assets on the fair value of the liability is asset-specific performance risk, not credit risk.

Determining the effects of changes in credit risk

B5.7.16 For the purposes of applying the requirement in paragraph 5.7.7(a), an entity shall determine the amount of change in the fair value of the financial liability that is attributable to changes in the credit risk of that liability either:

(a) as the amount of change in its fair value that is not attributable to changes in market conditions that give rise to market risk (see paragraphs B5.7.17 and B5.7.18); or

(b) using an alternative method the entity believes more faithfully represents the amount of change in the liability’s fair value that is attributable to changes in its credit risk.

B5.7.17 Changes in market conditions that give rise to market risk include changes in a benchmark interest rate, the price of another entity’s financial instrument, a commodity price, a foreign exchange rate or an index of prices or rates. 

B5.7.18 If the only significant relevant changes in market conditions for a liability are changes in an observed (benchmark) interest rate, the amount in paragraph B5.7.16(a) can be estimated as follows:

(a) First, the entity computes the liability’s internal rate of return at the start of the period using the fair value of the liability and the liability’s contractual cash flows at the start of the period.  It deducts from this rate of return the observed (benchmark) interest rate at the start of the period, to arrive at an instrument-specific component of the internal rate of return.

(b) Next, the entity calculates the present value of the cash flows associated with the liability using the liability’s contractual cash flows at the end of the period and a discount rate equal to the sum of (i) the observed (benchmark) interest rate at the end of the period and (ii) the instrument-specific component of the internal rate of return as determined in (a).

(c) The difference between the fair value of the liability at the end of the period and the amount determined in (b) is the change in fair value that is not attributable to changes in the observed (benchmark) interest rate.  This is the amount to be presented in other comprehensive income in accordance with paragraph 5.7.7(a).

B5.7.19 The example in paragraph B5.7.18 assumes that changes in fair value arising from factors other than changes in the instrument’s credit risk or changes in observed (benchmark) interest rates are not significant.  This method would not be appropriate if changes in fair value arising from other factors are significant.  In those cases, an entity is required to use an alternative method that more faithfully measures the effects of changes in the liability’s credit risk (see paragraph B5.7.16(b)).  For example, if the instrument in the example contains an embedded derivative, the change in fair value of the embedded derivative is excluded in determining the amount to be presented in other comprehensive income in accordance with paragraph 5.7.7(a).

B5.7.20 As with all fair value measurements, an entity’s measurement method for determining the portion of the change in the liability’s fair value that is attributable to changes in its credit risk must make maximum use of relevant observable inputs and minimum use of unobservable inputs. 

Hedge accounting (chapter 6)

Hedging instruments (section 6.2)

Qualifying instruments

B6.2.1 Derivatives that are embedded in hybrid contracts, but that are not separately accounted for, cannot be designated as separate hedging instruments.

B6.2.2 An entity’s own equity instruments are not financial assets or financial liabilities of the entity and therefore cannot be designated as hedging instruments.

B6.2.3 For hedges of foreign currency risk, the foreign currency risk component of a non-derivative financial instrument is determined in accordance with AASB 121.

Written options

B6.2.4 This Standard does not restrict the circumstances in which a derivative that is measured at fair value through profit or loss may be designated as a hedging instrument, except for some written options.  A written option does not qualify as a hedging instrument unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument (for example, a written call option used to hedge a callable liability).

Designation of hedging instruments

B6.2.5 For hedges other than hedges of foreign currency risk, when an entity designates a non-derivative financial asset or a non-derivative financial liability measured at fair value through profit or loss as a hedging instrument, it may only designate the non-derivative financial instrument in its entirety or a proportion of it.

B6.2.6 A single hedging instrument may be designated as a hedging instrument of more than one type of risk, provided that there is a specific designation of the hedging instrument and of the different risk positions as hedged items.  Those hedged items can be in different hedging relationships.

Hedged items (section 6.3)

Qualifying items

B6.3.1 A firm commitment to acquire a business in a business combination cannot be a hedged item, except for foreign currency risk, because the other risks being hedged cannot be specifically identified and measured.  Those other risks are general business risks.

B6.3.2 An equity method investment cannot be a hedged item in a fair value hedge.  This is because the equity method recognises in profit or loss the investor’s share of the investee’s profit or loss, rather than changes in the investment’s fair value.  For a similar reason, an investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge.  This is because consolidation recognises in profit or loss the subsidiary’s profit or loss, rather than changes in the investment’s fair value.  A hedge of a net investment in a foreign operation is different because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the value of the investment.

B6.3.3 Paragraph 6.3.4 permits an entity to designate as hedged items aggregated exposures that are a combination of an exposure and a derivative.  When designating such a hedged item, an entity assesses whether the aggregated exposure combines an exposure with a derivative so that it creates a different aggregated exposure that is managed as one exposure for a particular risk (or risks).  In that case, the entity may designate the hedged item on the basis of the aggregated exposure.  For example:

(a) an entity may hedge a given quantity of highly probable coffee purchases in 15 months’ time against price risk (based on US dollars) using a 15-month futures contract for coffee.  The highly probable coffee purchases and the futures contract for coffee in combination can be viewed as a 15-month fixed-amount US dollar foreign currency risk exposure for risk management purposes (ie like any fixed-amount US dollar cash outflow in 15 months’ time).

(b) an entity may hedge the foreign currency risk for the entire term of a 10-year fixed-rate debt denominated in a foreign currency.  However, the entity requires fixed-rate exposure in its functional currency only for a short to medium term (say two years) and floating rate exposure in its functional currency for the remaining term to maturity.  At the end of each of the two-year intervals (ie on a two-year rolling basis) the entity fixes the next two years’ interest rate exposure (if the interest level is such that the entity wants to fix interest rates).  In such a situation an entity may enter into a
10-year fixed-to-floating cross-currency interest rate swap that swaps the fixed-rate foreign currency debt into a variable-rate functional currency exposure.  This is overlaid with a two-year interest rate swap that – on the basis of the functional currency – swaps variable-rate debt into fixed-rate debt. In effect, the fixed-rate foreign currency debt and the 10-year fixed-to-floating cross-currency interest rate swap in combination are viewed as a 10-year variable-rate debt functional currency exposure for risk management purposes.

B6.3.4 When designating the hedged item on the basis of the aggregated exposure, an entity considers the combined effect of the items that constitute the aggregated exposure for the purpose of assessing hedge effectiveness and measuring hedge ineffectiveness.  However, the items that constitute the aggregated exposure remain accounted for separately.  This means that, for example:

(a) derivatives that are part of an aggregated exposure are recognised as separate assets or liabilities measured at fair value; and

(b) if a hedging relationship is designated between the items that constitute the aggregated exposure, the way in which a derivative is included as part of an aggregated exposure must be consistent with the designation of that derivative as the hedging instrument at the level of the aggregated exposure.  For example, if an entity excludes the forward element of a derivative from its designation as the hedging instrument for the hedging relationship between the items that constitute the aggregated exposure, it must also exclude the forward element when including that derivative as a hedged item as part of the aggregated exposure.  Otherwise, the aggregated exposure shall include a derivative, either in its entirety or a proportion of it.

B6.3.5 Paragraph 6.3.6 states that in consolidated financial statements the foreign currency risk of a highly probable forecast intragroup transaction may qualify as a hedged item in a cash flow hedge, provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and that the foreign currency risk will affect consolidated profit or loss.  For this purpose an entity can be a parent, subsidiary, associate, joint arrangement or branch.  If the foreign currency risk of a forecast intragroup transaction does not affect consolidated profit or loss, the intragroup transaction cannot qualify as a hedged item.  This is usually the case for royalty payments, interest payments or management charges between members of the same group, unless there is a related external transaction.  However, when the foreign currency risk of a forecast intragroup transaction will affect consolidated profit or loss, the intragroup transaction can qualify as a hedged item.  An example is forecast sales or purchases of inventories between members of the same group if there is an onward sale of the inventory to a party external to the group.  Similarly, a forecast intragroup sale of plant and equipment from the group entity that manufactured it to a group entity that will use the plant and equipment in its operations may affect consolidated profit or loss.  This could occur, for example, because the plant and equipment will be depreciated by the purchasing entity and the amount initially recognised for the plant and equipment may change if the forecast intragroup transaction is denominated in a currency other than the functional currency of the purchasing entity.

B6.3.6 If a hedge of a forecast intragroup transaction qualifies for hedge accounting, any gain or loss is recognised in, and taken out of, other comprehensive income in accordance with paragraph 6.5.11.  The relevant period or periods during which the foreign currency risk of the hedged transaction affects profit or loss is when it affects consolidated profit or loss.

Designation of hedged items

B6.3.7 A component is a hedged item that is less than the entire item.  Consequently, a component reflects only some of the risks of the item of which it is a part or reflects the risks only to some extent (for example, when designating a proportion of an item).

Risk components

B6.3.8 To be eligible for designation as a hedged item, a risk component must be a separately identifiable component of the financial or the non-financial item, and the changes in the cash flows or the fair value of the item attributable to changes in that risk component must be reliably measurable.

B6.3.9 When identifying what risk components qualify for designation as a hedged item, an entity assesses such risk components within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place.  Such a determination requires an evaluation of the relevant facts and circumstances, which differ by risk and market.

B6.3.10 When designating risk components as hedged items, an entity considers whether the risk components are explicitly specified in a contract (contractually specified risk components) or whether they are implicit in the fair value or the cash flows of an item of which they are a part (non-contractually specified risk components).  Non-contractually specified risk components can relate to items that are not a contract (for example, forecast transactions) or contracts that do not explicitly specify the component (for example, a firm commitment that includes only one single price instead of a pricing formula that references different underlyings).  For example:

(a) Entity A has a long-term supply contract for natural gas that is priced using a contractually specified formula that references commodities and other factors (for example, gas oil, fuel oil and other components such as transport charges).  Entity A hedges the gas oil component in that supply contract using a gas oil forward contract.  Because the gas oil component is specified by the terms and conditions of the supply contract it is a contractually specified risk component.  Hence, because of the pricing formula, Entity A concludes that the gas oil price exposure is separately identifiable.  At the same time, there is a market for gas oil forward contracts.  Hence, Entity A concludes that the gas oil price exposure is reliably measurable.  Consequently, the gas oil price exposure in the supply contract is a risk component that is eligible for designation as a hedged item.

(b) Entity B hedges its future coffee purchases based on its production forecast.  Hedging starts up to 15 months before delivery for part of the forecast purchase volume.  Entity B increases the hedged volume over time (as the delivery date approaches).  Entity B uses two different types of contracts to manage its coffee price risk:

(i) exchange-traded coffee futures contracts; and

(ii) coffee supply contracts for Arabica coffee from Colombia delivered to a specific manufacturing site.  These contracts price a tonne of coffee based on the exchange-traded coffee futures contract price plus a fixed price differential plus a variable logistics services charge using a pricing formula.  The coffee supply contract is an executory contract in accordance with which Entity B takes actual delivery of coffee.

 For deliveries that relate to the current harvest, entering into the coffee supply contracts allows Entity B to fix the price differential between the actual coffee quality purchased (Arabica coffee from Colombia) and the benchmark quality that is the underlying of the exchange-traded futures contract.  However, for deliveries that relate to the next harvest, the coffee supply contracts are not yet available, so the price differential cannot be fixed.  Entity B uses exchange-traded coffee futures contracts to hedge the benchmark quality component of its coffee price risk for deliveries that relate to the current harvest as well as the next harvest.  Entity B determines that it is exposed to three different risks: coffee price risk reflecting the benchmark quality, coffee price risk reflecting the difference (spread) between the price for the benchmark quality coffee and the particular Arabica coffee from Colombia that it actually receives, and the variable logistics costs.  For deliveries related to the current harvest, after Entity B enters into a coffee supply contract, the coffee price risk reflecting the benchmark quality is a contractually specified risk component because the pricing formula includes an indexation to the exchange-traded coffee futures contract price.  Entity B concludes that this risk component is separately identifiable and reliably measurable.  For deliveries related to the next harvest, Entity B has not yet entered into any coffee supply contracts (ie those deliveries are forecast transactions).  Hence, the coffee price risk reflecting the benchmark quality is a non-contractually specified risk component.  Entity B’s analysis of the market structure takes into account how eventual deliveries of the particular coffee that it receives are priced.  Hence, on the basis of this analysis of the market structure, Entity B concludes that the forecast transactions also involve the coffee price risk that reflects the benchmark quality as a risk component that is separately identifiable and reliably measurable even though it is not contractually specified.  Consequently, Entity B may designate hedging relationships on a risk components basis (for the coffee price risk that reflects the benchmark quality) for coffee supply contracts as well as forecast transactions.

(c) Entity C hedges part of its future jet fuel purchases on the basis of its consumption forecast up to 24 months before delivery and increases the volume that it hedges over time.  Entity C hedges this exposure using different types of contracts depending on the time horizon of the hedge, which affects the market liquidity of the derivatives.  For the longer time horizons (12–24 months) Entity C uses crude oil contracts because only these have sufficient market liquidity.  For time horizons of
6–12 months Entity C uses gas oil derivatives because they are sufficiently liquid.  For time horizons up to six months Entity C uses jet fuel contracts.  Entity C’s analysis of the market structure for oil and oil products and its evaluation of the relevant facts and circumstances is as follows:

(i) Entity C operates in a geographical area in which Brent is the crude oil benchmark.  Crude oil is a raw material benchmark that affects the price of various refined oil products as their most basic input.  Gas oil is a benchmark for refined oil products, which is used as a pricing reference for oil distillates more generally.  This is also reflected in the types of derivative financial instruments for the crude oil and refined oil products markets of the environment in which Entity C operates, such as:

• the benchmark crude oil futures contract, which is for Brent crude oil;
• the benchmark gas oil futures contract, which is used as the pricing reference for distillates—for example, jet fuel spread derivatives cover the price differential between jet fuel and that benchmark gas oil; and
• the benchmark gas oil crack spread derivative (ie the derivative for the price differential between crude oil and gas oil—a refining margin), which is indexed to Brent crude oil.

(ii) the pricing of refined oil products does not depend on which particular crude oil is processed by a particular refinery because those refined oil products (such as gas oil or jet fuel) are standardised products.

 Hence, Entity C concludes that the price risk of its jet fuel purchases includes a crude oil price risk component based on Brent crude oil and a gas oil price risk component, even though crude oil and gas oil are not specified in any contractual arrangement.  Entity C concludes that these two risk components are separately identifiable and reliably measurable even though they are not contractually specified.  Consequently, Entity C may designate hedging relationships for forecast jet fuel purchases on a risk components basis (for crude oil or gas oil).  This analysis also means that if, for example, Entity C used crude oil derivatives based on West Texas Intermediate (WTI) crude oil, changes in the price differential between Brent crude oil and WTI crude oil would cause hedge ineffectiveness.

(d) Entity D holds a fixed-rate debt instrument.  This instrument is issued in an environment with a market in which a large variety of similar debt instruments are compared by their spreads to a benchmark rate (for example, LIBOR) and variable-rate instruments in that environment are typically indexed to that benchmark rate.  Interest rate swaps are frequently used to manage interest rate risk on the basis of that benchmark rate, irrespective of the spread of debt instruments to that benchmark rate.  The price of fixed-rate debt instruments varies directly in response to changes in the benchmark rate as they happen.  Entity D concludes that the benchmark rate is a component that can be separately identified and reliably measured.  Consequently, Entity D may designate hedging relationships for the fixed-rate debt instrument on a risk component basis for the benchmark interest rate risk.

B6.3.11 When designating a risk component as a hedged item, the hedge accounting requirements apply to that risk component in the same way as they apply to other hedged items that are not risk components.  For example, the qualifying criteria apply, including that the hedging relationship must meet the hedge effectiveness requirements, and any hedge ineffectiveness must be measured and recognised.

B6.3.12 An entity can also designate only changes in the cash flows or fair value of a hedged item above or below a specified price or other variable (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.  For example, an entity can designate the variability of future cash flow outcomes resulting from a price increase of a forecast commodity purchase.  In such a situation, the entity designates only cash flow losses that result from an increase in the price above the specified level.  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.

B6.3.13 There is a rebuttable presumption that unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable and hence cannot be designated as a risk component of a financial instrument.  However, in limited cases, it is possible to identify a risk component for inflation risk that is separately identifiable and reliably measurable because of the particular circumstances of the inflation environment and the relevant debt market.

B6.3.14 For example, an entity issues debt in an environment in which inflation-linked bonds have a volume and term structure that results in a sufficiently liquid market that allows constructing a term structure of zero-coupon real interest rates.  This means that for the respective currency, inflation is a relevant factor that is separately considered by the debt markets.  In those circumstances the inflation risk component could be determined by discounting the cash flows of the hedged debt instrument using the term structure of zero-coupon real interest rates (ie in a manner similar to how a risk-free (nominal) interest rate component can be determined).  Conversely, in many cases an inflation risk component is not separately identifiable and reliably measurable.  For example, an entity issues only nominal interest rate debt in an environment with a market for inflation-linked bonds that is not sufficiently liquid to allow a term structure of zero-coupon real interest rates to be constructed.  In this case the analysis of the market structure and of the facts and circumstances does not support the entity concluding that inflation is a relevant factor that is separately considered by the debt markets.  Hence, the entity cannot overcome the rebuttable presumption that inflation risk that is not contractually specified is not separately identifiable and reliably measurable.  Consequently, an inflation risk component would not be eligible for designation as the hedged item.  This applies irrespective of any inflation hedging instrument that the entity has actually entered into.  In particular, the entity cannot simply impute the terms and conditions of the actual inflation hedging instrument by projecting its terms and conditions onto the nominal interest rate debt.

B6.3.15 A contractually specified inflation risk component of the cash flows of a recognised inflation-linked bond (assuming that there is no requirement to account for an embedded derivative separately) is separately identifiable and reliably measurable, as long as other cash flows of the instrument are not affected by the inflation risk component.

Components of a nominal amount

B6.3.16 There are two types of components of nominal amounts that can be designated as the hedged item in a hedging relationship: a component that is a proportion of an entire item or a layer component.  The type of component changes the accounting outcome.  An entity shall designate the component for accounting purposes consistently with its risk management objective.

B6.3.17 An example of a component that is a proportion is 50 per cent of the contractual cash flows of a loan.

B6.3.18 A layer component may be specified from a defined, but open, population, or from a defined nominal amount.  Examples include:

(a) part of a monetary transaction volume, for example, the next FC10 cash flows from sales denominated in a foreign currency after the first FC20 in March 201X;[2]

(b) a part of a physical volume, for example, the bottom layer, measuring 5 million cubic metres, of the natural gas stored in location XYZ;

(c) a part of a physical or other transaction volume, for example, the first 100 barrels of the oil purchases in June 201X or the first 100 MWh of electricity sales in June 201X; or

(d) a layer from the nominal amount of the hedged item, for example, the last CU80 million of a CU100 million firm commitment, the bottom layer of CU20 million of a CU100 million fixed-rate bond or the top layer of CU30 million from a total amount of CU100 million of fixed-rate debt that can be prepaid at fair value (the defined nominal amount is CU100 million).

B6.3.19 If a layer component is designated in a fair value hedge, an entity shall specify it from a defined nominal amount.  To comply with the requirements for qualifying fair value hedges, an entity shall remeasure the hedged item for fair value changes (ie remeasure the item for fair value changes attributable to the hedged risk).  The fair value hedge adjustment must be recognised in profit or loss no later than when the item is derecognised.  Consequently, it is necessary to track the item to which the fair value hedge adjustment relates.  For a layer component in a fair value hedge, this requires an entity to track the nominal amount from which it is defined.  For example, in paragraph B6.3.18(d), the total defined nominal amount of CU100 million must be tracked in order to track the bottom layer of CU20 million or the top layer of CU30 million.

B6.3.20 A layer component that includes a prepayment option is not eligible to be designated as a hedged item in a fair value hedge if the prepayment option’s fair value is affected by changes in the hedged risk, unless the designated layer includes the effect of the related prepayment option when determining the change in the fair value of the hedged item.

Relationship between components and the total cash flows of an item

B6.3.21 If a component of the cash flows of a financial or a non-financial item is designated as the hedged item, that component must be less than or equal to the total cash flows of the entire item.  However, all of the cash flows of the entire item may be designated as the hedged item and hedged for only one particular risk (for example, only for those changes that are attributable to changes in LIBOR or a benchmark commodity price).

B6.3.22 For example, in the case of a financial liability whose effective interest rate is below LIBOR, an entity cannot designate:

(a) a component of the liability equal to interest at LIBOR (plus the principal amount in case of a fair value hedge); and

(b) a negative residual component.

B6.3.23 However, in the case of a fixed-rate financial liability whose effective interest rate is (for example) 100 basis points below LIBOR, an entity can designate as the hedged item the change in the value of that entire liability (ie principal plus interest at LIBOR minus 100 basis points) that is attributable to changes in LIBOR.  If a fixed-rate financial instrument is hedged some time after its origination and interest rates have changed in the meantime, the entity can designate a risk component equal to a benchmark rate that is higher than the contractual rate paid on the item.  The entity can do so provided that the benchmark rate is less than the effective interest rate calculated on the assumption that the entity had purchased the instrument on the day when it first designates the hedged item.  For example, assume that an entity originates a fixed-rate financial asset of CU100 that has an effective interest rate of six per cent at a time when LIBOR is four per cent.  It begins to hedge that asset some time later when LIBOR has increased to eight per cent and the fair value of the asset has decreased to CU90.  The entity calculates that if it had purchased the asset on the date it first designates the related LIBOR interest rate risk as the hedged item, the effective yield of the asset based on its then fair value of CU90 would have been 9.5 per cent.  Because LIBOR is less than this effective yield, the entity can designate a LIBOR component of eight per cent that consists partly of the contractual interest cash flows and partly of the difference between the current fair value (ie CU90) and the amount repayable on maturity (ie CU100).

B6.3.24 If a variable-rate financial liability bears interest of (for example) three-month LIBOR minus 20 basis points (with a floor at zero basis points), an entity can designate as the hedged item the change in the cash flows of that entire liability (ie three-month LIBOR minus 20 basis points—including the floor) that is attributable to changes in LIBOR.  Hence, as long as the three-month LIBOR forward curve for the remaining life of that liability does not fall below 20 basis points, the hedged item has the same cash flow variability as a liability that bears interest at three-month LIBOR with a zero or positive spread.  However, if the three-month LIBOR forward curve for the remaining life of that liability (or a part of it) falls below 20 basis points, the hedged item has a lower cash flow variability than a liability that bears interest at three-month LIBOR with a zero or positive spread.

B6.3.25 A similar example of a non-financial item is a specific type of crude oil from a particular oil field that is priced off the relevant benchmark crude oil.  If an entity sells that crude oil under a contract using a contractual pricing formula that sets the price per barrel at the benchmark crude oil price minus CU10 with a floor of CU15, the entity can designate as the hedged item the entire cash flow variability under the sales contract that is attributable to the change in the benchmark crude oil price.  However, the entity cannot designate a component that is equal to the full change in the benchmark crude oil price.  Hence, as long as the forward price (for each delivery) does not fall below CU25, the hedged item has the same cash flow variability as a crude oil sale at the benchmark crude oil price (or with a positive spread).  However, if the forward price for any delivery falls below CU25, the hedged item has a lower cash flow variability than a crude oil sale at the benchmark crude oil price (or with a positive spread).

Qualifying criteria for hedge accounting (section 6.4)

Hedge effectiveness

B6.4.1 Hedge effectiveness is the extent to which changes in the fair value or the cash flows of the hedging instrument offset changes in the fair value or the cash flows of the hedged item (for example, when the hedged item is a risk component, the relevant change in fair value or cash flows of an item is the one that is attributable to the hedged risk).  Hedge ineffectiveness is the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those on the hedged item.

B6.4.2 When designating a hedging relationship and on an ongoing basis, an entity shall analyse the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its term.  This analysis (including any updates in accordance with paragraph B6.5.21 arising from rebalancing a hedging relationship) is the basis for the entity’s assessment of meeting the hedge effectiveness requirements.

B6.4.3 For the avoidance of doubt, the effects of replacing the original counterparty with a clearing counterparty and making the associated changes as described in paragraph 6.5.6 shall be reflected in the measurement of the hedging instrument and therefore in the assessment of hedge effectiveness and the measurement of hedge effectiveness.

Economic relationship between the hedged item and the hedging instrument

B6.4.4 The requirement that an economic relationship exists means that the hedging instrument and the hedged item have values that generally move in the opposite direction because of the same risk, which is the hedged risk.  Hence, there must be an expectation that the value of the hedging instrument and the value of the hedged item will systematically change in response to movements in either the same underlying or underlyings that are economically related in such a way that they respond in a similar way to the risk that is being hedged (for example, Brent and WTI crude oil).

B6.4.5 If the underlyings are not the same but are economically related, there can be situations in which the values of the hedging instrument and the hedged item move in the same direction, for example, because the price differential between the two related underlyings changes while the underlyings themselves do not move significantly.  That is still consistent with an economic relationship between the hedging instrument and the hedged item if the values of the hedging instrument and the hedged item are still expected to typically move in the opposite direction when the underlyings move.

B6.4.6 The assessment of whether an economic relationship exists includes an analysis of the possible behaviour of the hedging relationship during its term to ascertain whether it can be expected to meet the risk management objective.  The mere existence of a statistical correlation between two variables does not, by itself, support a valid conclusion that an economic relationship exists.

The effect of credit risk

B6.4.7 Because the hedge accounting model is based on a general notion of offset between gains and losses on the hedging instrument and the hedged item, hedge effectiveness is determined not only by the economic relationship between those items (ie the changes in their underlyings) but also by the effect of credit risk on the value of both the hedging instrument and the hedged item.  The effect of credit risk means that even if there is an economic relationship between the hedging instrument and the hedged item, the level of offset might become erratic.  This can result from a change in the credit risk of either the hedging instrument or the hedged item that is of such a magnitude that the credit risk dominates the value changes that result from the economic relationship (ie the effect of the changes in the underlyings).  A level of magnitude that gives rise to dominance is one that would result in the loss (or gain) from credit risk frustrating the effect of changes in the underlyings on the value of the hedging instrument or the hedged item, even if those changes were significant.  Conversely, if during a particular period there is little change in the underlyings, the fact that even small credit risk-related changes in the value of the hedging instrument or the hedged item might affect the value more than the underlyings does not create dominance.

B6.4.8 An example of credit risk dominating a hedging relationship is when an entity hedges an exposure to commodity price risk using an uncollateralised derivative.  If the counterparty to that derivative experiences a severe deterioration in its credit standing, the effect of the changes in the counterparty’s credit standing might outweigh the effect of changes in the commodity price on the fair value of the hedging instrument, whereas changes in the value of the hedged item depend largely on the commodity price changes.

Hedge ratio

B6.4.9 In accordance with the hedge effectiveness requirements, the hedge ratio of the hedging relationship must be the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.  Hence, if an entity hedges less than 100 per cent of the exposure on an item, such as 85 per cent, it shall designate the hedging relationship using a hedge ratio that is the same as that resulting from 85 per cent of the exposure and the quantity of the hedging instrument that the entity actually uses to hedge those 85 per cent.  Similarly, if, for example, an entity hedges an exposure using a nominal amount of 40 units of a financial instrument, it shall designate the hedging relationship using a hedge ratio that is the same as that resulting from that quantity of 40 units (ie the entity must not use a hedge ratio based on a higher quantity of units that it might hold in total or a lower quantity of units) and the quantity of the hedged item that it actually hedges with those 40 units.

B6.4.10 However, the designation of the hedging relationship using the same hedge ratio as that resulting from the quantities of the hedged item and the hedging instrument that the entity actually uses shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would in turn create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.  Hence, for the purpose of designating a hedging relationship, an entity must adjust the hedge ratio that results from the quantities of the hedged item and the hedging instrument that the entity actually uses if that is needed to avoid such an imbalance.

B6.4.11 Examples of relevant considerations in assessing whether an accounting outcome is inconsistent with the purpose of hedge accounting are:

(a) whether the intended hedge ratio is established to avoid recognising hedge ineffectiveness for cash flow hedges, or to achieve fair value hedge adjustments for more hedged items with the aim of increasing the use of fair value accounting, but without offsetting fair value changes of the hedging instrument; and

(b) whether there is a commercial reason for the particular weightings of the hedged item and the hedging instrument, even though that creates hedge ineffectiveness.  For example, an entity enters into and designates a quantity of the hedging instrument that is not the quantity that it determined as the best hedge of the hedged item because the standard volume of the hedging instruments does not allow it to enter into that exact quantity of hedging instrument (a ‘lot size issue’).  An example is an entity that hedges 100 tonnes of coffee purchases with standard coffee futures contracts that have a contract size of 37,500 lbs (pounds).  The entity could only use either five or six contracts (equivalent to 85.0 and 102.1 tonnes respectively) to hedge the purchase volume of 100 tonnes.  In that case, the entity designates the hedging relationship using the hedge ratio that results from the number of coffee futures contracts that it actually uses, because the hedge ineffectiveness resulting from the mismatch in the weightings of the hedged item and the hedging instrument would not result in an accounting outcome that is inconsistent with the purpose of hedge accounting.

Frequency of assessing whether the hedge effectiveness requirements are met

B6.4.12 An entity shall assess at the inception of the hedging relationship, and on an ongoing basis, whether a hedging relationship meets the hedge effectiveness requirements.  At a minimum, an entity shall perform the ongoing assessment at each reporting date or upon a significant change in the circumstances affecting the hedge effectiveness requirements, whichever comes first.  The assessment relates to expectations about hedge effectiveness and is therefore only forward-looking.

Methods for assessing whether the hedge effectiveness requirements are met

B6.4.13 This Standard does not specify a method for assessing whether a hedging relationship meets the hedge effectiveness requirements.  However, an entity shall use a method that captures the relevant characteristics of the hedging relationship including the sources of hedge ineffectiveness.  Depending on those factors, the method can be a qualitative or a quantitative assessment.

B6.4.14 For example, when the critical terms (such as the nominal amount, maturity and underlying) of the hedging instrument and the hedged item match or are closely aligned, it might be possible for an entity to conclude on the basis of a qualitative assessment of those critical terms that the hedging instrument and the hedged item have values that will generally move in the opposite direction because of the same risk and hence that an economic relationship exists between the hedged item and the hedging instrument (see paragraphs B6.4.4-B6.4.6).

B6.4.15 The fact that a derivative is in or out of the money when it is designated as a hedging instrument does not in itself mean that a qualitative assessment is inappropriate.  It depends on the circumstances whether hedge ineffectiveness arising from that fact could have a magnitude that a qualitative assessment would not adequately capture.

B6.4.16 Conversely, if the critical terms of the hedging instrument and the hedged item are not closely aligned, there is an increased level of uncertainty about the extent of offset.  Consequently, the hedge effectiveness during the term of the hedging relationship is more difficult to predict.  In such a situation it might only be possible for an entity to conclude on the basis of a quantitative assessment that an economic relationship exists between the hedged item and the hedging instrument (see paragraphs B6.4.4-B6.4.6).  In some situations a quantitative assessment might also be needed to assess whether the hedge ratio used for designating the hedging relationship meets the hedge effectiveness requirements (see paragraphs B6.4.9-B6.4.11).  An entity can use the same or different methods for those two different purposes.

B6.4.17 If there are changes in circumstances that affect hedge effectiveness, an entity may have to change the method for assessing whether a hedging relationship meets the hedge effectiveness requirements in order to ensure that the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness, are still captured.

B6.4.18 An entity’s risk management is the main source of information to perform the assessment of whether a hedging relationship meets the hedge effectiveness requirements.  This means that the management information (or analysis) used for decision-making purposes can be used as a basis for assessing whether a hedging relationship meets the hedge effectiveness requirements.

B6.4.19 An entity’s documentation of the hedging relationship includes how it will assess the hedge effectiveness requirements, including the method or methods used.  The documentation of the hedging relationship shall be updated for any changes to the methods (see paragraph B6.4.17).

Accounting for qualifying hedging relationships (section 6.5)

B6.5.1 An example of a fair value hedge is a hedge of exposure to changes in the fair value of a fixed-rate debt instrument arising from changes in interest rates.  Such a hedge could be entered into by the issuer or by the holder.

B6.5.2 The purpose of a cash flow hedge is to defer the gain or loss on the hedging instrument to a period or periods in which the hedged expected future cash flows affect profit or loss.  An example of a cash flow hedge is the use of a swap to change floating rate debt (whether measured at amortised cost or fair value) to fixed-rate debt (ie a hedge of a future transaction in which the future cash flows being hedged are the future interest payments).  Conversely, a forecast purchase of an equity instrument that, once acquired, will be accounted for at fair value through profit or loss, is an example of an item that cannot be the hedged item in a cash flow hedge, because any gain or loss on the hedging instrument that would be deferred could not be appropriately reclassified to profit or loss during a period in which it would achieve offset.  For the same reason, a forecast purchase of an equity instrument that, once acquired, will be accounted for at fair value with changes in fair value presented in other comprehensive income also cannot be the hedged item in a cash flow hedge.

B6.5.3 A hedge of a firm commitment (for example, a hedge of the change in fuel price relating to an unrecognised contractual commitment by an electric utility to purchase fuel at a fixed price) is a hedge of an exposure to a change in fair value.  Accordingly, such a hedge is a fair value hedge.  However, in accordance with paragraph 6.5.4, a hedge of the foreign currency risk of a firm commitment could alternatively be accounted for as a cash flow hedge.

Measurement of hedge ineffectiveness

B6.5.4 When measuring hedge ineffectiveness, an entity shall consider the time value of money.  Consequently, the entity determines the value of the hedged item on a present value basis and therefore the change in the value of the hedged item also includes the effect of the time value of money.

B6.5.5 To calculate the change in the value of the hedged item for the purpose of measuring hedge ineffectiveness, an entity may use a derivative that would have terms that match the critical terms of the hedged item (this is commonly referred to as a ‘hypothetical derivative’), and, for example for a hedge of a forecast transaction, would be calibrated using the hedged price (or rate) level.  For example, if the hedge was for a two-sided risk at the current market level, the hypothetical derivative would represent a hypothetical forward contract that is calibrated to a value of nil at the time of designation of the hedging relationship.  If the hedge was for example for a one-sided risk, the hypothetical derivative would represent the intrinsic value of a hypothetical option that at the time of designation of the hedging relationship is at the money if the hedged price level is the current market level, or out of the money if the hedged price level is above (or, for a hedge of a long position, below) the current market level.  Using a hypothetical derivative is one possible way of calculating the change in the value of the hedged item.  The hypothetical derivative replicates the hedged item and hence results in the same outcome as if that change in value was determined by a different approach.  Hence, using a ‘hypothetical derivative’ is not a method in its own right but a mathematical expedient that can only be used to calculate the value of the hedged item.  Consequently, a ‘hypothetical derivative’ cannot be used to include features in the value of the hedged item that only exist in the hedging instrument (but not in the hedged item).  An example is debt denominated in a foreign currency (irrespective of whether it is fixed-rate or variable-rate debt).  When using a hypothetical derivative to calculate the change in the value of such debt or the present value of the cumulative change in its cash flows, the hypothetical derivative cannot simply impute a charge for exchanging different currencies even though actual derivatives under which different currencies are exchanged might include such a charge (for example, cross-currency interest rate swaps).

B6.5.6 The change in the value of the hedged item determined using a hypothetical derivative may also be used for the purpose of assessing whether a hedging relationship meets the hedge effectiveness requirements.

Rebalancing the hedging relationship and changes to the hedge ratio

B6.5.7 Rebalancing refers to the adjustments made to the designated quantities of the hedged item or the hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements.  Changes to designated quantities of a hedged item or of a hedging instrument for a different purpose do not constitute rebalancing for the purpose of this Standard.

B6.5.8 Rebalancing is accounted for as a continuation of the hedging relationship in accordance with paragraphs B6.5.9-B6.5.21.  On rebalancing, the hedge ineffectiveness of the hedging relationship is determined and recognised immediately before adjusting the hedging relationship.