16/01/2015. FRS 102 & financial instruments basic and other debt instruments. FRS 102 & financial instruments basic and other debt instruments

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FRS 102 & financial instruments basic and other debt instruments 20 January 2015 Download the slides to accompany the webinar /FRFwebinarresources FRS

1 FRS 102 & financial instruments basic and other debt instruments 20 January 2015 Download the slides to accompany the webinar /FRFwebinarresources FRS 102 & financial instruments basic and other debt instruments 20 January 2015 Introduction Marianne Mau Technical Manager, Financial Reporting Faculty 1

Introduction Helen Shaw Senior Manager Deloitte Eddy James Technical Manager Financial Reporting Faculty Ask a question Participate in today s webinar send us a question Audio

2 Introduction Helen Shaw Senior Manager Deloitte Eddy James Technical Manager Financial Reporting Faculty 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) 2

3 Contents Introduction Basic and other debt instruments Amortised cost vs. fair value Intercompany loans Impairment of financial assets FRS 102 & financial instruments INTRODUCTION Introduction Sections 11 & 12 of FRS 102 are derived from the corresponding sections of the IFRS for SMEs The IFRS for SMEs was published in 2009 and based on IFRSs at that time The classification & measurement requirements of Sections 11 & 12 are different to those of: IAS 39 Financial instruments: recognition and measurement; IFRS 9 Financial instruments; and Old UK GAAP The requirements were amended in July 2014 in response to concerns that the criteria for classifying debt instruments as basic were too restrictive Entities yet to publish their first set of FRS 102 financial statements need only consider the revised requirements 3

4 What is a basic financial instrument? Cash Debt instruments that meet certain conditions Investments in preference shares that are not puttable or convertible Investments in ordinary shares that are not puttable Loan commitments that: i) can not be settled net in cash; and ii) when executed will result in a basic debt instrument The instruments above are basic and so in the scope of Section 11 All other financial instruments are other and so in the scope of Section 12 Impact on measurement Cash Debt instruments that meet certain conditions Investments in preference shares that are not puttable or convertible. Investments in ordinary shares that are not puttable Loan commitments that: i) can not be settled net in cash; and ii) when executed will result in a basic debt instrument Other financial instruments (everything else) Amortised cost FVTPL or cost FVTPL or cost Cost FVTPL* *Limited exceptions for some unquoted equity instruments, hedging instruments or if prohibited by law FRS 102 & financial instruments BASIC AND OTHER DEBT INSTRUMENTS 4

5 Debt instruments: approach to classification Basic/other classification is based on specific rules rather than an overarching principle. Some features of debt instruments that may be regarded as simple and/or common may not be considered basic under Section 11. In order to be basic, a debt instrument must comply with all of the conditions and a single contractual term may impact more than one of the conditions. Derivatives Variation in returns Prepayment options Returns Loss of principal or interest Extension options Derivatives FRS (b) lists the following as examples of instruments that do not normally meet the conditions for basic classification: Options, rights, warrants, futures contracts, forward contracts and interest rate swaps that can be settled in cash or by exchanging another financial instrument Derivative financial instruments (with the exception of basic loan commitments) can never be basic. Debt instruments described in FRS (b) can not be classified as basic. The instruments listed in this paragraph are all derivatives. The list is not exhaustive. However, any derivative instrument not listed would not meet the other conditions for classification as basic. Debt instruments: returns The returns to the holder are assessed in the currency in which the debt instrument is denominated. To qualify as basic an instrument must have returns that are: a fixed amount; a positive fixed rate or a positive variable rate; or a combination of a positive or a negative fixed rate and a positive variable rate Zero coupon bond Inverse floater The return on a zero coupon bond is a fixed amount so, if there are no other features in the contractual terms that result in any variability in the contractual cash flows, the instrument will be basic. A debt instrument that pays interest at a rate of 5% less LIBOR is not basic because it is the combination of a positive fixed rate and a negative variable rate. 5

6 Debt instruments: meaning of variable rate A variable rate for the purpose of basic/other classification is a rate which varies over time and is linked to: a single observable interest rate; or a single relevant observable index of general price inflation of the currency in which the instrument is denominated, provided such links are not leveraged. Convertible debt An investment in a bond that is convertible into a fixed number of shares is not basic as the return is variable and linked to the value of the equity of the issuer. Loan paying 2x SVR A loan with interest referenced to two times the bank s SVR is not basic as, although SVR is a single observable interest rate, the link is leveraged. Mortgage linked to HPI A mortgage linked to the UK Land Registry House Price Index (HPI) is not basic because HPI is not a measure of general price inflation. Debt instruments: variation in return Different rates of return may apply in different periods of an instrument s life. To qualify as basic, the return in each period must meet the conditions for returns and the variation in return must be determinable. If the variation in rate is contingent of events other than: a change in a contractual variable rate; to protect the holder against credit deterioration of the issuer; or changes in levies applied by a central bank, or arising from changes in relevant tax or law; The new rate of return must also be a market rate. Floating rate loan with a cap A loan with a stated maturity date that pays a variable rate equal to a single observable interest rate where the variable rate is capped at 5% is basic. This is because the return meets the conditions for returns in any given period, and the variation of the interest rate is contingent on a change in the contractual variable rate Debt instruments: loss of principal or accrued interest An instrument cannot be basic if there is a contractual provision that could 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. Where there is a combination of a positive variable rate and a negative fixed rate the combined rate would breach this condition if the combined rate was not itself positive. Option to repay at fair value Floating debt with -ve margin A loan with an option to repay at fair value is not basic because the repayment amount could be less than the accrued interest and principal outstanding. A debt instrument that pays LIBOR less 10% is not basic because the combined rate is negative. In other scenarios more judgement may be required to make an assessment the combined rate. 6

Debt instruments: prepayment options In order for an instrument to be basic, prepayment options must not be contingent on future events other than to protect: the holder against the credit

7 Debt instruments: prepayment options In order for an instrument to be basic, prepayment options must not be contingent on future events other than to protect: 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 the holder or issuer against changes in levies applied by a central bank or arising from changes in relevant taxation or law. Must consider the impact of termination payments on other conditions for qualification as basic. If payment is compensation for termination it will not breach this condition. Option to repay at par If the borrower has the option to repay a debt instrument at par plus accrued interest, the prepayment feature will not prevent the loan from being classified as basic. This is because the right to prepay is not contingent on future events. Debt instruments: extension options An extension option will not prevent an instrument from being classified as basic if the return to the holder and any other contractual provisions applicable during the extended term meet the conditions for qualification as basic. Basic loan Basic loan commitment Basic loan Should also consider the requirements for variation in return on exercise of the extension option. Debt instruments: fair value option A basic debt instrument (or basic loan commitment) may be designated at FVTPL if one of the two following conditions is met: Designation at FVTPL eliminates or significantly reduces a measurement or recognition inconsistency For example, an entity issues fixed rate debt and at the same time trades an interest rate swap to economically hedge the interest rate risk Designation must be made on initial recognition (exception on transition) A group of financial assets, financial liabilities or both is managed and its performance is evaluated on a fair value basis Must be in accordance with a documented risk management strategy and information provided to management eg, an Investment portfolio Designation is irrevocable 7

8 Poll 1 Will any of your bank loans or those of your clients fail to be classified as basic? FRS 102 & financial instruments AMORTISED COST VS. FAIR VALUE Amortised cost measurement Amortised cost Initial recognition amount Any cash flows eg, principal repayments Interest calculated using the effective interest method Impairment (financial assets only) 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 Estimate cash flows considering all contractual terms of the financial instrument (eg, prepayment, call and similar options) and known credit losses that have been incurred, but it shall not consider possible future credit losses not yet incurred. Similar (but not identical) to recognising finance costs at a constant rate on carrying amount under FRS 4 8

9 Example On 1 January 20X1, an entity takes out a bank loan for 1m, incurring an arrangement fee of 100,000. Interest of 50,000 is payable annually, in arrears, over the next five years. The loan is repayable on 31 December 20X5. The arrangement fee is spread over the life of the instrument as interest expense. As a result, the effective interest rate of % is higher than the coupon rate of 5%. Year Carrying amount at beginning of period Interest expense at % Carrying Cash amount at end outflow of period 20X X X X X , Fair value measurement The following hierarchy should be used to estimate fair value: The quoted price for an identical asset in an active market The price of a recent transaction for an identical asset adjusted where necessary to ensure it reflects the entity s best estimate of fair value Valuation techniques such as discounted cash flow analysis or option pricing models Fair valuing debt instruments which are classified as other rather than basic may entail using complicated valuation techniques. Entities will need to consider how to obtain a valuation eg, asking their bank or using a valuation package. Doing so on a timely basis is advisable. Poll 2 Have you made any progress on establishing fair values? 9

FRS 102 & financial instruments INTERCOMPANY LOANS Intercompany loans Many intercompany loans are likely to be basic financial instruments. As such they will generally be measured at amortised cost.

10 FRS 102 & financial instruments INTERCOMPANY LOANS Intercompany loans Many intercompany loans are likely to be basic financial instruments. As such they will generally be measured at amortised cost. Term loans at zero or below market interest rates Loans with no fixed term The application of the standard will mean that such loans will be recorded at less than their nominal amount on initial recognition There is some uncertainty about how such loans should be treated as the standard is not clear on this point This difference will generally be accounted for as a capital contribution or distribution Our view is that such loans should be treated as repayable on demand and measured at nominal value unless there are contractual terms that indicate otherwise Example On 1 January 20X1, a company lends its subsidiary 5m at a zero rate of interest. The loan is repayable on 31 December 20X4. The market rate of interest for similar debt instruments is 3%. Under current UK GAAP, the loan would simply be recorded at 5m and no interest would be recognised. However, under FRS 102 the amortised cost method must be applied with the loan initially being recognised at its present value of 5m/ = 4.442m and then subsequently being accounted for as follows: Year Carrying amount at beginning of period Interest expense at 3% Carrying Cash amount at end outflow of period 20X X X X On initial recognition the discount of 5,000,000-4,442,435 = 557,565 would be recognised directly in equity, as a transaction with owners. 10

11 FRS 102 & financial instruments IMPAIRMENT OF FINANCIAL ASSETS Impairment of financial assets When objective evidence of impairment exists, an impairment loss must be recognised immediately in profit or loss. Financial assets can generally be assessed for impairment either individually or grouped on the basis of similar credit risk characteristics. For financial assets measured at amortised cost, the impairment loss is the difference between the asset s carrying amount and the present value of the estimated future cash flows Impairment losses must be reversed when a subsequent change in the asset s value or expected cash flows can be objectively linked to an event after the impairment was recognised Any questions? 11

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Webinars 24 February FRS 102: practical issues 18 March FRS 102 & financial instruments: hedging /webinars THANK YOU FOR

13 Questions Helen Shaw Senior Manager Deloitte Eddy James Technical Manager Financial Reporting Faculty Future events and webinars Events 28 April London Financial Instruments under new UK GAAP Details of our roadshow series coming soon /frfevents Webinars 24 February FRS 102: practical issues 18 March FRS 102 & financial instruments: hedging /webinars THANK YOU FOR ATTENDING Contact the Financial Reporting Faculty +44 (0) Please take the time to fill out our short survey 13

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16/03/2015. FRS 102 & financial instruments hedging. FRS 102 & financial instruments hedging. Introduction

16/03/2015. FRS 102 & financial instruments hedging. FRS 102 & financial instruments hedging. Introduction FRS 102 & financial instruments hedging 18 March 2015 Download the slides to accompany the webinar /FRFwebinarresources FRS 102 & financial instruments hedging 18 March 2015 Introduction Marianne Mau Technical