Measurement and Hedging

IAS 39 Financial Instruments: Recognition and Measurement

Measurement and hedging

Under existing UK requirements, financial instruments are generally carried at amortised cost - less impairment provisions in the case of financial assets - although some entities mark-to-market trading books with changes in value recognised in the profit and loss account. IAS 39 requires specific measurement bases to be applied to different categories of financial instrument, which would require a number of significant changes to existing UK practice.

Under IAS 39, all derivatives, and nonderivative financial instruments held for trading purposes, must be measured at fair value with changes in value recognised in the profit and loss account. This also applies to certain derivative-like features - including some prepayment options or settlement options - that are incorporated into a non-derivative contract, which must be separated from the main contract and accounted for as a derivative. IAS 39

allows any other financial asset or liability, when initially recognised, to be designated as being at ‘fair value through profit or loss’. This ‘fair value option’ may simplify the accounting in certain circumstances. Detailed rules for the method of determining fair value are set out, including requirements for the use of valuation models for instruments that are not traded on a market.

Other financial assets that are loans or other receivables and are not traded on a market are measured on an amortised cost basis. Accrual of interest must be calculated on the effective yield basis which spreads the interest, together with any initial fees or costs, over the life of the asset at a constant yield. Financial liabilities are also measured at amortised cost, unless the option to designate them as at ‘fair value through profit or loss’ is chosen.

Securities and other financial assets that the entity has the intention and ability to hold to maturity and which meet certain other criteria may be classified as ‘held to maturity’ and measured on the amortised cost basis; however, disposal of any such held-tomaturity assets before maturity will restrict use of this accounting for the future. Other financial assets not falling within one of the above categories are treated as ‘available for sale’ and measured at fair value. Changes in their fair value are recognised directly as part of equity and only included in the profit and loss account when they are realised.

All assets, other than those held for trading or measured at fair value under the ‘fair value through profit or loss’ option must be tested for impairment in accordance with the detailed methods set out in the IAS.

All derivatives must be measured at fair value, whether used for hedging or trading purposes - unlike current UK practice, where hedging derivatives such as interest rate swaps are often accounted for on an amortised cost basis to match the accounting treatment of the hedged item. IAS 39 permits special hedge accounting, allowing recognition of gains or losses on the hedged item in some circumstances but imposes strict requirements for hedge designation and effectiveness testing of the hedge relationship - whereas existing UK standards do not address hedge accounting other than hedges of net investments in foreign operations.

Derecognition

IAS 39 also addresses the circumstances in which an entity should cease to recognise (derecognise) financial assets and financial liabilities. This material has important consequences for the accounting treatment of financing arrangements that involve the transfer of rights to future cash flows,