EFFECTIVE INTEREST RATE METHOD AMORTIZATION

Transcription

1 EFFECTIVE INTEREST RATE METHOD AMORTIZATION

2 BACKGROUND NI requires disclosure of interest income If interest income disclosed IAS 39 requires the use of the effective interest rate (EIR) method of amortization to account for interest income IFRS does not require separate disclosure of interest income for financial assets measured at FVTPL (IFRS 7.20) Substantially all mutual funds in Canada have currently not provided interest income disclosure based on EIR amortization. Accordingly most systems are not designed to calculate EIR amortization Tax requirements for interest income accounting are on a coupon basis except for deep discount bonds which are done on a straight line basis. Current systems are designed to provide this information which is also used for accounting purposes Income tax reporting requirements to the CRA will not change with the move to IFRS 2

3 COMPLEXITIES WITH EIR AMORTIZATION IN A HELD FOR TRADING PORTFOLIO Bonds (by issuer) are frequently traded and the positions held are accumulated over time. Each individual position could be an accumulation of purchases (net of sales) over a considerable time period. EIR amortization of these positions is difficult and cumbersome Even if systems are changed for EIR amortization the fund will have to maintain dual records for the tax calculations on the current basis resulting in additional costs for unitholders Until system changes are carried out funds will have to manually calculate EIR amortizations to record interest income only in situations where the EIR amortization compared to the current method is material Complexity of materiality judgements As this is a regulatory requirement fund managers will have to assess the difference between EIR amortization and the current method for each holding of a fixed income instrument irrespective of whether the holdings are a significant component of the portfolio 3

4 EIR AMORTIZATION ISSUES WITH ESTIMATION As positions are accumulated over time each holding would have different purchase dates and arriving at a date of purchase from which amortization commences is a cumbersome exercise As the positions are frequently traded amortization of premiums and discounts to maturity is irrelevant and therefore IFRS does not require this disclosure for HFT investments Any impairments in positions held will require amortization and further complicate the calculations Embedded derivatives would also need to be considered However, impairments and embedded derivatives are not generally considered relevant for instruments carried at FV- the only reason would be for EIM calculations 4

5 EIR AMORTIZATION COSTS INVOLVED WITH COMPLYING WITH NI System changes are expensive and dual records will be required to comply with NI and CRA tax requirements Until system changes are made EIR amortization will need to be estimated twice a year and will be a costly exercise Fund managers will have to make judgment calls on materiality to determine which funds are most impacted by the EIR amortization. Fund managers and auditors will have to determine whether the manual EIR method is appropriate (true approximation of EIR) Further to the above the auditor will have to document their conclusions on each fund to support the judgments made which will increase audit costs If fund managers do not disclose interest on the income statement auditors are not in a position to qualify the audit report as the financial statements will still be compliant with IFRS 5

6 CURRENT DISCUSSIONS WITH THE REGULATORS Understand regulators views where financial statements do not disclose interest income on the statement of comprehensive income. Interest received will be disclosed on the cash flow statement which is a new requirement under IFRS Note that the EIR amortization results in a reclassification adjustment between realized/unrealized gains and interest income with no impact on total income or NAV A meeting with the OSC has been scheduled for November 7, 2013 Various other solutions are being discussed amongst the audit firms and industry and these will be proposed to the regulators 6

7 PROPOSED SOLUTION WHERE SYSTEM CHANGES ARE IN PROCESS Fund managers will need to determine whether EIR amortization will be material to a particular fund. This could be carried out in a two step process as follows: Determine whether the total premiums and discounts in a fund on a net basis is material to the fund. Materiality for this item should be discussed with the auditors Where premiums and discounts are immaterial, the difference between EIR and current reporting may not be significant For funds where the total premiums and discounts are material a further analysis of amortizing the premiums and discounts over the remaining life of the security on a straight line basis may be carried out. If the annual amortization using the SL method is not material then the difference between EIR and current reporting may not be significant For funds where the straight line amortization is material a further exercise using EIR amortization would be required on the portfolio to determine whether the EIR amortization is material and this may be recorded in the FS 7

8 MANUAL SOLUTION FOR EIR AMORTIZATION For funds where the EIR amortization could be material the following data points on each individual holding are required to carry out the EIR amortization: par value, carrying value, coupon, date of purchase, date of maturity An excel spreadsheet can be developed to do this calculation which provides the current carrying under effective interest Most of the above data points are available on the SOI except for date of purchase which could be an accumulation of a number of trades Without breaking down each holding by date of purchase this calculation will need to be done by estimating the date of purchase for each holding. This will not be an easy exercise for frequently traded positions The solution will only be able to calculate the carrying value of the portfolio using EIR method at the FS date and by comparing the change in carrying values between two FS dates the reclassification adjustment can be booked 8

9 SAMPLE SPREADSHEET Security Par Carrying value Date of Issue/purchase Maturity Coupon Effective Yield EIR Amort CV Province of Ontario 2,200,000 2,000, ,200,000 Province of Ontario 230, , ,766 Province of Ontario 8,000,000 7,200, ,383,006 Province of Ontario 540, , ,000 Province of Ontario 2,200,000 2,000, ,087,485 Province of Ontario 230, , ,092 Province of Ontario 340, , ,795 Province of Ontario 540, , ,000 Province of Ontario 2,200,000 2,000, ,097,361 Province of Ontario 230, , ,960 Province of Ontario 340, , ,232 Province of Ontario 540, , ,000 Province of Ontario 2,200,000 2,000, ,112,684 Province of Ontario 230, , ,954 Province of Ontario 340, , ,938 Province of Ontario 540, , ,000 Province of Ontario 300, , ,069 Province of Ontario 540, , ,000 Province of Ontario 2,200,000 2,000, ,122,734 Province of Ontario 900,000 1,000, ,000 41,199,000 37,730,000 39,432,145 Accumulated amortization 1,702,145