20/03/2014. New UK GAAP Accounting for financial instruments 20 March 2014 Download the slides to accompany the webinar icaew.com/frfwebinarresources

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1 New UK GAAP Accounting for financial instruments 20 March 2014 Download the slides to accompany the webinar /FRFwebinarresources Introduction Sarah Porthouse Technical Manager, Financial Reporting Faculty Introduction Ian Ogilvy Advisory Accountant HMRC Eddy James Technical Manager Financial Reporting Faculty 1

2 Ask a question Participate in today s webinar send us a question Audio problems if you experience poor sound quality you may benefit from selecting Use Telephone from your Audio Mode settings Downloading the slides /FRFwebinars (/FRFwebinarresources) Contents Basic financial instruments Other financial instruments Hedging Impairment of financial assets Transition 2

3 New UK GAAP accounting for financial instruments BASIC FINANCIAL INSTRUMENTS Accounting policy choice Under FRS 102 entities can choose between Applying sections 11 & 12 of FRS 102 in full; or Applying the recognition & measurement provisions of IAS 39 and the disclosure requirements of sections 11 & 12; or Applying the recognition & measurement provisions of IFRS 9 and the disclosure requirements of sections 11 & 12 Today s webinar assumes that entities will be applying sections 11 & 12 of FRS 102 Basic financial instruments Section 11 Straightforward terms eg, trade debtors, trade creditors, simple bank loans and many investments Generally measured at amortised cost Short-term debtors & creditors at undiscounted amount of cash receivable ie, invoice price Investments in non-convertible preference shares and non-puttable ordinary or preference shares at either fair value or cost less impairment 3

4 Basic financial instruments Long-term debtors Financing transactions - payment deferred or not at market interest rates Long-term creditors Financing transactions - payment deferred or not at market interest rates Simple bank loans Provided they meet the conditions of paragraph 11.9 of FRS 102 Initial measurement Present value of cash receivable Present value of cash payable Present value of cash payable Subsequent measurement Amortised cost Amortised cost Amortised cost Impairment testing Carrying amount vs. present value of estimated cash flows Basic financial instruments Investments in debt Bonds, debentures etc Investments in shares Where fair value cannot be reliably measured Initial measurement Transaction price including transaction costs Transaction price including transaction costs Subsequent measurement Amortised cost Cost less impairments Impairment testing Carrying amount vs. present value of estimated cash flows Carrying amount vs. estimated selling price Investments in shares Publicly traded or where fair value can otherwise be reliably measured Transaction price excluding transaction costs At fair value with gains & losses in profit or loss Which bank loans are simple? A debt instrument that satisfies all of the conditions in (a) to (d) below shall be accounted for in accordance with Section 11: (a) Returns to the holder are: (i) a fixed amount; (ii) a fixed rate of return over the life of the instrument; (iii) a variable return that, throughout the life of the instrument, is equal to a single referenced quoted or observable interest rate (such as LIBOR); or (iv) some combination of such fixed rate and variable rates (such as LIBOR plus 200 basis points), provided that both the fixed and variable rates are positive (eg an interest rate swap with a positive fixed rate and negative variable rate would not meet this criterion). For fixed and variable rate interest returns, interest is calculated by multiplying the rate for the applicable period by the principal amount outstanding during the period. 4

5 Which bank loans are simple? A debt instrument that satisfies all of the conditions in (a) to (d) below shall be accounted for in accordance with Section 11: (b) There is no contractual provision that could, by its terms, result in the holder losing the principal amount or any interest attributable to the current period or prior periods. The fact that a debt instrument is subordinated to other debt instruments is not an example of such a contractual provision. (c) Contractual provisions that permit the issuer (the borrower) to prepay a debt instrument or permit the holder (the lender) to put it back to the issuer before maturity are 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. (d) There are no conditional returns or repayment provisions except for the variable rate return described in (a) and prepayment provisions described in (c). Which bank loans are simple? Some seemingly simple features may result in the loan being classified as other and measured at fair value Caps, floors or both Stepped interest features Combinations of fixed and variable rates Interest rates such as LIBOR minus x% Certain prepayment provisions Certain options to extend Many of these loans would not be fair valued under IFRS 9 Poll 1 - How do you think your business s bank loans or those of your clients will be classified under FRS 102? 5

6 Latest proposals FRED 54 Good news Allows a wider range of debt instruments to be measured at amortised cost Appendix of examples added to section 11 to illustrate the application of the revised requirements Bad news Retains a rules-based approach Some more complex debt instruments still measured at fair value Measuring fair value Active market Quoted market price Price of recent transactions of identical assets Valuation techniques eg, discounted cash flows No active market Still should normally be possible to estimate fair value of ordinary shares or preference shares If can t reliably estimate, measure at cost less impairments New UK GAAP accounting for financial instruments OTHER FINANCIAL INSTRUMENTS 6

7 Other financial instruments Section 12 Those that are not basic More complex bank loans eg, where interest rates are linked to commodity prices or equity prices Derivatives such as foreign exchange forward contracts and interest rate swaps Almost all at fair value through profit or loss Derivatives Current UK GAAP FRS 102 Often not recognised on-balance sheet. Gains and losses recognised on settlement Classified as other financial instruments and therefore recognised on-balance sheet at fair value with movements recognised in profit or loss Foreign exchange forward contracts Current UK GAAP FRS 102 Contracted rate can be used in some cases FX contract recognised onbalance sheet as a financial instrument at fair value and the associated debtor or creditor retranslated at the year-end rate 7

8 Example A UK entity sells goods to a US customer on 1 November 20X1. The invoice is for $100,000 for settlement in 3 months ie, 31 January 20X2. On 1 November 20X1, the entity enters into a forward contract to sell $100,000 on 31 January 20X2 at a contracted rate of 1.62:$1. The entity has a 31 December year end. Details of GBP to USD exchange rates are below: Date Spot rate Forward rate to 31 January 20X2 1 November 20X December 20X January 20X Solution SSAP 20 FRS November 20X1 Sales 61,728 62, December 20X1 Fx gain on debtor Loss on derivative - - 1,194 (1,165) 31 January 20X2 FX gain on debtor Loss on derivative (1,623) TOTAL 61,728 61,728 New UK GAAP accounting for financial instruments HEDGING 8

9 Hedging Current UK GAAP FRS 102 No specific requirements on hedge accounting Hedge accounting can be applied in certain situations provided specified criteria are met Hedge accounting is optional When is hedge accounting needed? No need for hedge accounting Both gains or losses on the asset or liability creating the exposure and gains or losses on the hedging instrument are reported through profit and loss Natural offset in profit or loss Hedging fx risk on a foreign currency trade receivable Hedged item: receivable Hedging instrument: forward contract 2014 X X No mismatch When is hedge accounting needed? Cash flow hedge Item creating the exposure not recognised as the risk relates to a transaction that has not yet actually happened Hedge accounting is needed to eliminate accounting mismatches and ensure that the accounting faithfully represents the hedging activity Hedging fx risk on highly probably forecast transaction Hedged item: forecast transaction Hedging instrument: forward contract X X Mismatch 9

10 When is hedge accounting needed? Fair value hedge Hedged item measured at cost or amortised cost Hedge accounting is needed to eliminate accounting mismatches and ensure that the accounting faithfully represents the hedging activity Hedging commodity price risk Hedged item: stock of oil Hedging instrument: forward contract X X Mismatch Qualifying for hedge accounting Designation and documentation of hedging relationship Hedged risk meets specified criteria Hedging instrument meet specified criteria Expects the hedge to be highly effective in offsetting the designated hedged risk Eligible hedged risks and hedging instruments Hedged risks Interest rate risk and fx risk of a debt instrument measurement at amortised cost Interest rate risk and fx risk of a firm commitment or highly probable forecast transaction Price risk of a commodity that the entity holds or has a firm commitment or highly probable forecast transaction to purchase or sell Fx risk in a net investment in a foreign operation Hedging instruments Interest rate swaps Foreign currency swaps Cross currency interest rate swaps Forward or future foreign currency exchange contract Forward or future commodity exchange contract 10

11 Pros and cons of hedge accounting Cons Not linked to common risk management practices May need to alter hedging strategy Costly or impossible to apply in practice Pros Reduced P&L volatility Accounting better reflects the economic substance of the transaction Poll 2 - Do you engage in hedging activities? Latest proposals FRED 51 Good news Replaces existing rules-based approach with a simplified version of IFRS 9 s new principles-based approach Better aligns hedge accounting model with risk management activities More eligible hedged risks and hedging instruments No need to make an upfront assessment of hedge effectiveness at the beginning of a hedging relationship Bad news Documentation and designation still required Some common risk management strategies may still not qualify for hedge accounting eg, hedges of net positions and risk components 11

12 New UK GAAP accounting for financial instruments IMPAIRMENT OF FINANCIAL ASSETS Impairment of financial assets The FRC had intended to revise FRS 102 before its effective date to reflect IFRS 9 s updated impairment requirements The IASB has, however, yet to complete its impairment project It now seems highly unlikely that FRS 102 will be amended in the short-term FRS 102 s requirements are more prescriptive than current UK GAAP but are nonetheless largely consistent with existing practice New UK GAAP accounting for financial instruments TRANSITION 12

13 Transition identifying financial instruments Identify all financial instruments Some may not currently be accounted for eg, derivatives Understand terms Understand what is changing because of FRED 54 Are they basic or other? Will any financial instruments be measured at fair value? Transition measurement & hedging Instruments measured at fair value Sourcing the valuations Hedge accounting Understand what is changing because of FRED 51 If important and material should it be documented? Any questions? 13

14 Ask a question Participate in today s webinar send us a question Click here to see questions Questions Ian Ogilvy Advisory Accountant HMRC Topics covered today Basic financial instruments Other financial instruments Hedging Impairment of financial assets Transition Eddy James Technical Manager Financial Reporting Faculty Visit our website /newukgaap 14

15 Factsheets Future webinars and events Webinars 21 May The new IFRS on revenue recognition 18 June Tax implications of moving to FRS 102 /webinars Events Financial reporting faculty roadshow Preparing to move to the new UK GAAP CPD training First time adoption workshop 24 Oct UK GAAP conference /events THANK YOU FOR ATTENDING Contact the Financial Reporting Faculty +44 (0) /frf Previous webinars /frfwebinars Please take the time to fill out our short survey 15

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