Accounting and Reporting Policy FRS 102. Staff Education Note 2 Debt instruments - Amortised cost

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1 Accounting and Reporting Policy FRS 102 Staff Education Note 2 Debt instruments - Amortised cost Disclaimer This Education Note has been prepared by FRC staff for the convenience of users of FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland. It aims to illustrate certain requirements of FRS 102, but should not be relied upon as a definitive statement on the application of the standard. The illustrative material is not a substitute for reading the detailed requirements of FRS 102

2 Contents Page Introduction 2 Amortised cost measurement requirements in FRS Applying the effective interest method in practice 4 Effective interest method 4 Amortisation period 4 Measurment of common debt instruments 5 Debt repayable on demand 5 Current trade debtors (receivables) and trade creditors (payables) 5 Financial assets and liabilities bearing a market rate of interest 5 Financial assets and liabilities bearing zero or a below market rate of interest 6 Example 1: Below market rate of interest loan 6 Deferred payment on the sale of goods or services 8 Example 2: Deferred payment on the sale of goods 8 Page 1

3 Introduction FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, Section 11 Basic Financial Instruments requires that basic debt instruments, which include basic types of loans and other receivables and payables, shall be measured at amortised cost using the effective interest method. This Education Note discusses aspects of the application of the amortised cost measurement requirements in FRS 102 and indicates whether entities should expect accounting differences on transition when applying the amortised cost measurement requirements of FRS 102 for the first time. This Education Note is written from the perspective of reporting entities that do not apply FRS 26 (IAS 39) Financial instruments: recognition and measurement and assumes that pre-transition accounting policies are based on the requirements of FRS 4 Capital instruments. This Education Note highlights some common key areas for consideration when transitioning to FRS 102, but is not in any way meant to be exhaustive and should therefore not be used as a substitute for a thorough analysis. The FRC intends to issue a supplementary exposure draft on impairment of finanical assets when the IASB finalises the impairment accounting requirements of IFRS 9 Financial Instruments. Therefore certain paragraphs of Section 11 of FRS 102 referred to below, may be subject to change. Page 2

4 Amortised cost measurement requirements in FRS 102 Paragraphs to of FRS 102 provide guidance on how to calculate amortised cost using the effective interest method. Paragraphs and are reproduced below: The amortised cost of a financial asset or financial liability at each reporting date is the net of the following amounts: (a) (b) (c) (d) the amount at which the financial asset or financial liability is measured at initial recognition; minus any repayments of the principal; plus or minus the cumulative amortisation using the effective interest method of any difference between the amount at initial recognition and the maturity amount; minus, in the case of a financial asset, any reduction (directly or through the use of an allowance account) for impairment or uncollectability. Financial assets and financial liabilities that have no stated interest rate (and do not constitute a financing transaction) and are classified as payable or receivable within one year are initially measured at an undiscounted amount in accordance with paragraph 11.14(a). Therefore, (c) above does not apply to them The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or a group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period, to the carrying amount of the financial asset or financial liability. The effective interest rate is determined on the basis of the carrying amount of the financial asset or liability at initial recognition. Under the effective interest method: (a) (b) the amortised cost of a financial asset (liability) is the present value of future cash receipts (payments) discounted at the effective interest rate; and the interest expense (income) in a period equals the carrying amount of the financial liability (asset) at the beginning of a period multiplied by the effective interest rate for the period. Page 3

5 Applying the effective interest method in practice Effective interest method In accordance with paragraph 11.14(a) of FRS 102 debt instruments that meet the conditions of paragraphs 11.8(b) and 11.9 shall, following initial recognition, be measured at amortised cost using the effective interest method. Debt instruments include basic types of financial assets and liabilities, eg trade receivables and payables and variable or fixed rate loans. Please note that paragraph 11.14(b) also provides an alternative accounting treatment and entities may elect to measure their debt instruments at fair value which is not discussed in this document. Paragraphs and of FRS 102 (reproduced above) set out the basic principles of an amortised cost calculation and describe how the effective interest rate method should be applied. The effective interest rate of a debt instrument may equal its coupon rate, but, often an entity will also incur other costs or receive other income associated with the instrument, eg finance charges or premiums and discounts which affect the effective interest rate. The effective interest rate includes, besides interest, other related finance fees and charges (refer also to paragraph of FRS 102). Please also refer to the example of an amortisation cost calculation in Section 11 of FRS 102. It is not expected that accounting differences will arise in respect of the determination of the effective interest rate when transitioning to FRS 102, since similar principles apply under FRS 4 Capital Instruments, provided the interest rate of the loan is a market rate of interest (see below for more detail). Amortisation period In order to calculate the effective interest rate, an entity has to determine the expected life of the debt instrument. A shorter period than the expected life should be used under certain circumstances. This is typically the case when certain fees, finance charges or other transaction costs relate to a period shorter than the expected life of the debt instrument (paragraphs and of FRS 102). On transition, entities should assess whether amortisation periods used to calculate the effective interest rate are in accordance with the requirements of FRS 102. Generally no accounting difference is expected, however, in some specific situations, eg debts with early redemption options differences may arise. Page 4

6 Measurement of common debt instruments Debt repayable on demand For financial liabilities, if a creditor has the right to demand repayment at any time, the borrower measures the liability at the undiscounted amount of cash borrowed less any subsequent repayments, provided the loan bears a market rate of interest. If the loan does bear a below market rate of interest (ie it is a financing transaction, as described in paragraph of FRS 102, see below for more detail), the liability is measured at the present value of future payments discounted at a market rate of interest for a similar loan. By way of example, a standard bank overdraft repayable on demand would be measured at the principal amount of the overdraft. Current trade debtors (receivables) and trade creditors (payables) Under FRS 102, trade receivables (debtors) and trade payables (creditors) are recognised at the transaction price (unless the arrangement is a financing transaction as described in paragraph of FRS 102, see below for more detail), which in most cases is the invoiced amount (refer to the examples in paragraph of FRS 102). In accordance with paragraph 11.14(a) of FRS 102 receivables and payables due within one year continue to be measured after their initial recognition at the undiscounted amount of cash or other consideration expected to be paid or received. Therefore in most situations short term receivables and payables are measured at their invoiced amount until they are settled or otherwise extinguished. Trade receivables are subject to impairment and must not be stated at a value higher than their recoverable amount. More information on the accounting for impairment of trade receivables can be found in Staff Education Note 3: Impairment of trade debtors. It is not expected that accounting differences will arise in respect of current trade receivables and trade payables when transitioning to FRS 102. Financial assets and liabilities bearing a market rate of interest Paragraph of FRS 102 requires that financial assets and liabilities are initially recorded at the transaction price (unless it is a financing transaction as described in paragraph of FRS 102, see below for more detail). Financial assets and liabilities bearing a market rate of interest will therefore be recognised at the initial value exchanged (ie the amount of the cash lent or received) including transaction costs. Debt instruments that meet the conditions of a basic debt instrument set out in paragraphs 11.8(b) and 11.9 of FRS 102 are measured at amortised cost after initial recognition. Provided no transaction costs have been incurred or premiums/discounts have been paid/received, for debt instruments bearing a market rate of interest, the effective interest rate is equal to their market rate of interest at the date of initial recognition. It is not expected that accounting differences will arise in respect of debt instruments bearing a market rate of interest when transitioning to FRS 102. Page 5

7 Financial assets and liabilities bearing zero or a below market rate of interest FRS 102 sets out discreet measurement requirements for financial instruments that are subject to an arrangement which in effect constitutes a financing transaction. Paragraph of FRS 102 describes when a financing transaction may take place. It includes arrangements where financing is provided or received at an interest rate that is not a market rate. This may occur when interest is charged at a discount to the typical market rate, or the loan is provided interest-free. A typical example is an interest-free loan provided to a group company. Please note that a zero-coupon bond would not constitute a financing transaction merely by the virtue of the stated coupon rate being zero percent. In accordance with paragraph of FRS 102 financial assets and liabilities subject to finance transactions should be measured initially at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. FRS 102 does not contain requirements about how any excess or shortfall between the amounts of cash received or advanced and the initial carrying value of the loan should be accounted for. It may be appropriate to record such excess or shortfall in profit or loss or in some special circumstances as a capital contribution. Each entity should consider the particular facts of the underlying transactions in order to record it appropriately. Financial assets and liabilities subject to a financing transaction that are debt instruments and meet the condition of paragraph 11.8(b) of FRS 102, are subsequently measured at amortised cost (paragraph 11.14(a) of FRS 102). Example 1: Below market rate of interest loan On 1 January 20X1, Company A obtains a loan of CU10,000 from another group company. The loan is repayable in full on 31 December 20X2. The loan has been made at a preferential rate of 5% per annum. The market rate of interest for similar loans is 10% per annum. Interest is paid annually in arrears. The net present value of the loan on 1 January 20X1 is calculated as follows: Year Discount factor (10%) Cash flow CU Net present value CU 20X X , , , The amortised cost of the loan as at 31 December 20X1 and 20X2 is calculated as follows: Year Carrying amount at 1 January Interest charged (10%) Cash flow Carrying amount at 31 December CU CU CU CU 20X1 9, (500.00) 9, X2 9, (10,500.00) 0.00 The accounting requirements for loans made at zero or below a market rate of interest under FRS 102 are not identical to the accounting treatment of such instruments under FRS 4. It is therefore expected that accounting differences may arise on transition. Page 6

8 The table below highlights the key differences between the accounting under FRS 4 and FRS 102. FRS 4 FRS 102 Borrower The loan is recognised initially at the amount of the net proceeds 1, which in most cases would be the amount borrowed. (FRS 4 paragraph 27) Finance costs are defined as the difference between the net proceeds and the total payments. (FRS 4 paragraph 8) The finance costs should be allocated over the term of the debt at a constant rate on the amount borrowed. (FRS 4 paragraph 28) The transaction constitutes, in effect, a financing transaction and the financial liability shall be measured at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. (FRS 102 paragraph 11.13) Over the period of the loan, interest payable will be calculated and added to the loan using the effective interest method. Lender No specific accounting requirements apply (FRS 4.19 excludes investments in capital instruments from its scope) and current practice would be to recognise the loan at the amount advanced. The transaction constitutes, in effect, a financing transaction and the financial asset shall be measured at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. (FRS 102 paragraph 11.13) Over the period of the loan, interest receivable will be added to the loan using the effective interest method. 1 Defined in paragraph 11 of FRS 4 as the fair value of the consideration received on the issue of a capital instrument after deduction of issue costs. Page 7

9 Deferred payment on the sale of goods or services Financial assets and liabilities arising from sales and purchases of goods and services on credit are measured at the transaction price (see above for more detail), unless the arrangement constitutes a financing transaction. A financing transaction exists when payment for goods or services is deferred beyond normal business terms. Paragraph of FRS 102 requires that financial assets and liabilities subject to a financing transaction are initially measured at their present value of the future payments discounted at a market rate of interest for a similar debt instrument. The cash price for the goods or services is normally good evidence of the present value and, if known, may be used to initially measure the financial asset or liability. After initial recognition, in accordance with paragraph 11.14(a) of FRS 102 the financial assets and liabilities are measured at amortised cost using the effective interest method, provided the financial assets and liabilities are debt instruments and meet the conditions of paragraphs 11.8(b) and 11.9 of FRS 102. Short-term receivables and payables, ie those that fall due within one year, resulting from financing transaction continue to be measured at their initial present value, which is normally the cash price for the underlying goods or services. No interest is therefore recognised in respect of these short term receivables and payables. Example 2: Deferred payment on the sale of goods On 1 January 20X1, a furniture retailer sells a sofa to a customer on credit for CU3,000, agreeing with the customer that full payment is due in two years time. Normal business terms are to sell goods for cash and the current cash price for the sofa is CU2,500. The initial carrying amount of the financial asset (trade receivable) recognised by the retailer is equal to the cash price of CU2,500. In accordance with paragraph 23.5 of FRS 102 the retailer also records a sale at the same present value, ie the cash price. The effective interest rate is 9.545% (the effective interest rate has to be calculated). The retailer calculates the amortised cost and interest based on the effective interest rate method as shown below. In accordance with paragraph 23.5 of FRS 102 the interest component in this arrangement is recorded as interest revenue. Year Carrying amount at 1 January Interest (9.545%) Cash flow Carrying amount at 31 December CU CU CU CU 20X1 2, ,739 20X2 2, (3,000) 0 On transition, parties (lender and borrower) to deferred payment term arrangements should assess whether their existing accounting practices are consistent with the requirements of FRS 102. Differences are not necessarily expected to arise on transition, but this has to be analysed on a case by case basis. The table below highlights the key differences between current UK GAAP and FRS 102. Page 8

10 FRS 4/ FRS 5 FRS 102 Borrower (purchaser of the goods/services on extended credit terms) FRS 4 Capital instruments characterises a capital instrument as a means of raising finance. This transaction relates to a purchase on credit terms that are extended to the extent that there is a financing element to the transaction. The debt is recognised at the net proceeds, assumed to be the fair value of the goods or services received. The difference between the fair value and the amount to be paid is the finance cost, to be allocated to periods over the term of the debt at a constant rate on the carrying amount. (FRS 4 paragraphs 27 and 28) This transaction is a financing transaction and the financial liability shall be measured at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. If the cash price for the transaction was known, it would provide evidence of the present value of the transaction from which the effective interest rate could be calculated. Interest payable would be recognised over the period of the loan. (FRS 102 paragraph 11.13) Lender (seller of the goods/services on extended credit terms) Revenue and the corresponding receivable are initially recognised at the fair value of the right to consideration, taking account of the effect of the time value of money, if material. (FRS 5 Application Note G) Revenue and the corresponding receivable are initially measured at the fair value of the consideration receivable. (FRS 102 paragraph 23.3) Where the inflow of cash is deferred, and the arrangement constitutes in effect a financing transaction, the fair value of the consideration is the present value of all future receipts determined using an imputed rate of interest. (FRS 102 paragraph 23.5) Page 9