Chapter 4 to 6 extract from our ExPress notes for use with the current video. A full set of F2 ExPress notes can be downloaded free of charge at www.. Notes CIMA Paper F2 Financial Management
Contents About ExPress Notes 3 1. Group Accounting 7 2. IAS 21 15 3. IAS 7 20 4. IAS 19 25 5. IAS 39 28 6. IFRS 2 33 7. Financial Management 35 8. Developments in External reporting 40 Page 2
Chapter 4 IAS 19 START The Big Picture Promises of pensions payable to staff are an expense of the sponsoring company. The act of making a promise to pay pensions creates an obligation (ie liability). This may be a liability to pay pension funds into a private pension plan, or a liability to pay a pension between retirement and death, depending on the pension type. There are two types of pension plan: defined contribution and defined benefit. Pension costs are fairly frequently examined. Although they seem difficult at first, they are surprisingly easy to deal with after working a few examples. To master the subject, you need to have: A good working understanding of double entry bookkeeping To understand the transaction itself (ie how a promise is made and assets set aside to cover the cost of honouring that promise) A methodical step-by-step approach to dealing with the numbers in a logical, chronological, sequence. Page 25
Defined contribution These are easy. The employer makes contributions into a savings scheme for the employee. All risks of the fund being inadequate to support the employee between retirement and death rest with the employee, not with the employer. They are therefore much more risky for the employee than for the employer. The accounting is simple: Impact on SOFP: None. Impact on SOCI: Contributions payable into the pension plan are an expense. Defined benefit plans These are considerably more complicated for the accountant and considerably more risky for the employer. Here, the employer promises to make future pension payments (an obligation, therefore a liability). Impact on SOFP: Pension plan assets (ringfenced assets from which future pensions will be paid). Pension plan liability (NPV of pensions promised by the year-end) Deferred costs and income (see below) Impact on SOCI: The cost of pensions promised in the year (current service cost and past service cost) Actuarial gains/ losses The increase in the pensions liability by the passage of time (interest cost) The long-term growth in pension plan assets in the year (expected return on plan assets) Recognised actuarial gains and losses (see below). If a pension plan is perfectly in balance, then the assets will precisely equal the liabilities. This is unlikely ever to happen, as the valuation of investments will be volatile. Also, assumptions about the actuarial liability (ie expected cost of paying an uncertain amount to Page 26
pensioners until they die) will vary year by year. It is normal for a pension plan therefore to be slightly out of balance. Deficit Assets Liabilities These unexpected movements give an actuarial gain or loss each period and are always a balancing item in the calculations, since (by definition) they are unexpected! Key definitions These are ExP s definitions, which are simplified for exam preparation purposes Current service cost Past service cost Interest (expense) The NPV of the extra pensions promised to staff in return for work they did this period. Defined benefit plans are characterised by offering greater pensions to people who have worked for the company longer, so one extra period of service increases pensions liability. The NPV of the extra pensions promised to staff in return for work they did in the past. This is much less common than current service cost and might happen only if a company needs to eliminate an actuarial surplus on the pension plan. The pensions liability is shown at NPV, as there can often be decades between the promise of the pension being paid and it actually being paid. The NPV is therefore a lot less than the actual cash expected to be paid. As time passes, the liability will grow just by passage of time, similar to unwinding of discounts on initial recognition of provisions. Page 27
Chapter 5 IAS 39 START The Big Picture Although financial instruments appear frequently in the F2 exam, they are only at level 2 knowledge within the syllabus. This means that the scenarios in which they are tested are likely to be relatively straightforward. It s easy to spend too much time preparing for these accounting standards, since they cover a huge array of different possible transactions, from regular trade receivables to exotic currency and interest rate swaps. The best way to approach study is to know: The four different classifications of all financial instruments The difference in fair value and amortised cost accounting The possible ways in which any gain or loss (whether on a financial instrument or not) may be reported in financial statements. If you are keen to take this as far as you can, then move on to study hedging, though this has generally only been worth a couple of marks in the exam. Page 28
When used... Example... Example that can t be categorised this way Initial recognised value Year-end valuation method Held-to-maturity financial assets When have the ability and positive intention to hold a security to its stated maturity date. Investment in corporate bonds or government bonds. Ordinary shares, as no maturity date. Nothing can be HTMFA if the entity has reclassified any investment out of HTMFA in the preceding two years. Cost paid, including transaction costs. Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased. Loans and receivables When have loaned a third party money (to a maturity date) or have an amount receivable (eg trade receivables). Originated loan to a third party (eg a bank lending a loan to a homebuyer). - Initial cash advanced, plus transaction costs. Amortised cost, less impairments. Impaired value estimated using revised cash flows, discounted at the original discount rate when the investment was purchased. Gains or losses reported in... Profit or loss Profit or loss When used... Financial asset or liability held at fair value through profit or loss Almost anything can be categorised as FVPL at its initial recognition (notably not debt issued by the entity itself). Securities held for trading will be classified as FVPL. Available-for-sale financial assets A catch-all category. Anything not in either of the other categories will be AFSFA. Typically, where investor stands ready to sell the security but has no immediate plans to. Example... Shares held for trading. Shares held for intermediate term investment. Example that can t be categorised this way - - Page 29
Initial recognised value Year-end valuation method Cash paid to acquire. Transaction costs immediately written off to profit or loss. Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid ask spread). Cash paid to acquire. Transaction costs added to initial value of investment. Fair value. Best achievable market price, not deducting anticipated selling costs (though at the lower end of the bid ask spread). Gains or losses reported in... Profit or loss Initially gain or loss reported in equity until sold, when the gain or loss is recycled (ie reported again) in profit. Reclassication To prevent creative accounting, reclassifying from one category of financial instruments to another is strongly discouraged by IAS 39. If a material held-to-maturity financial asset is reclassified out of held-to-maturity financial assets, then: All other held-to-maturity financial assets must be immediately reclassified as available for sale, with immediate recognition of all gain or loss (para 52, IAS 39). For that year and the two years thereafter, it is barred from classifying anything as held-tomaturity financial assets (para 9, IAS 39). Impairments All financial assets held at fair value are automatically revalued for impairments. If a heldto-maturity asset appears to be impaired (eg if the credit risk increases a great deal), then the new impaired value must be calculated using: The revised expected cash flows and expected timing At the original discount rate. Note that discounting the revised cash flows at the new rate (which would be higher, as the risk has increased) would double count the risk factor and result in undervaluation of the asset. Page 30
Hedging The Big Picture Hedging has only occasionally been tested in paper F2. It is common in practice and useful knowledge. Becoming expert in hedging should not be a top priority for most students studying for paper F2, since it can take a lot of time to master for a relatively low profile in the exam itself. Key workings/ methods Hedged item: The thing the enterprise is worried about changing in value, eg: Foreign currency investment Foreign currency payable Variable interest rate loan resulting in higher than expected cash outflows Forecast future major purchase in a foreign currency becoming unaffordable due to changes in the exchange rate. To remove or reduce this risk, the entity may buy something that is expected to move in value in the opposite direction to the hedged item. This counterweight is the hedging instrument and may be an almost infinite number of different financial instruments, though derivatives are common. Understanding the intricacies of how hedging relationships may be set up is not important for paper F2. It s useful to know how to account for movements in the hedged item and the hedging instrument. Though three types of hedge are mentioned in IAS 39, there are only two accounting treatments for hedges, so there are basically two types of hedge: Fair value hedge. The hedging instrument was taken out in order to protect against value changes of an item recognised in the SOFP. Eg a foreign currency loan to protect against a foreign exchange change in value of a foreign currency receivable that is being shown in the SOFP. Cash flow hedge. A hedge that is not a fair value hedge, broadly! This might be to protect against adverse movements in an item not in the SOFP yet. Eg an entity may Page 31
structure its business plan around buying a ship from a foreign ship builder, but it has not yet placed a binding order. As there is no binding order, there is no obligation, so there is no liability. The forecast/ intended transaction is not yet a liability, though the company will want to ensure that they can afford the expected future cash outflow. To protect against adverse exchange movements making the ship unaffordable, the entity may hedge the foreign currency exposure, eg buy buying a foreign currency forward contract. Accounting for hedges A fair value hedge is simple. Both the hedged item and hedging instrument will be in the SOFP and will record a gain and a loss. The accounting rules simply offset the gain on the hedged item with the loss on the hedging instrument, or vice versa. A cash flow hedge is a bigger challenge for the writers of the IAS! The hedging instrument will be a contract, so will be in the SOFP, but the hedged item will be an intention, so is not in the SOFP. Since the hedging instrument exists only because of the expected existence of the hedged item, the gain or loss on the hedging instrument is hidden in equity until the hedged transaction takes place. Page 32
Chapter 6 IFRS 2 START The Big Picture Prior to IFRS 2, listed companies often paid senior staff in shares that were issued below market value. These shares were then sold at a profit by the holders, with two effects: The holder made a profit on sale, which in substance was part of their total remuneration, and The other shareholders lost wealth (ie suffered an expense) as the share price fell by new shares being issued below market price. Prior to IFRS 2, this was simply recorded as: Dr Cash (with actual cash received, below market value) Cr Capital/ share premium account. IFRS 2 remedies this by making an estimate of the loss to other shareholders by granting cheap shares and spreading that cost over the period the company gains benefit from the share scheme. IFRS 2 is an unpopular accounting standard with many preparers of accounts, who say that it generates artificial expenses, brings in highly subjective valuations as expenses and repeats the same information as IAS 33 diluted earnings per share. Page 33
KEY KNOWLEDGE Suggested approach to questions 1 Decide whether the scheme is entirely payment in shares, is a payment in cash that is linked to the share price or some mix of the two. This decides how the share based payment is valued, as the rules are different for pure equity schemes and schemes in cash. Equity settled: The holder is paid only in shares. He/ she has no right to a cash alternative. 1A For an equity settled transaction, estimate the total benefit of the share plan to the holders by multiplying the total number of cheap shares to be issued by the option of the share at its grant date. This option value will be given in the exam. It is then frozen at the value per share at the grant date it is never updated. 1B For a cash based payment, estimate the total liability that the plan generates. As this is a liability, it must be revalued at the end of each period to its latest value. 2 3 Work out the vesting period. That is the period that staff must stay in the company s employment to be able to exercise their options over cheap shares. This is the period over which the cost/ benefit of the share option plan will be spread. Work out the cost of the share based payment each period, as: Latest estimate of total cost of the plan X (Expected total cost) Divided by years between grant and vesting date X (Total cost to date) Less: Costs cumulatively already recognised (X) Current period expense X Page 34