IFRS Roadshows 2012 IFRS and treasury strategy
1. Main accounting changes on financial instruments 2. Hedge accounting 3. Potential changes from IFRS 9 4. Challenges 5. Pensions accounting
1. Main accounting changes on financial instruments Horribly complex and subject to change when (if!) IFRS 9 is finalised Requires recognition at fair value of many instruments not presently recognised at all Recognition is based on a different basis from current UK GAAP
What is a financial instrument? A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity (11.3) Note: this is a very broad definition and many items are financial instruments but outside the remit of treasury functions
1. Main accounting changes on financial instruments Splits instruments into either basic or other Basic is defined tightly Basic is further split depending on whether it is a financing transaction or not
1. Main accounting changes on financial instruments Basic financial instruments (11.8) a) Cash b) A debt instrument meeting definition on next slide c) A commitment to receive a loan meeting definition on next slide d) An investment in non-convertible preference shares and non-puttable ordinary or preference shares
1. Main accounting changes on financial instruments Basic financial instruments (11.9) Must meet all of the following conditions: a) Returns to the holder are one of the following: i. A fixed amount ii. iii. iv. At a fixed rate of return A variable rate equal to a single quoted or observable interest rate A combination of the above (provided all positive)
1. Main accounting changes on financial instruments Basic financial instruments (11.9) Must meet all of the following conditions: b) No contractual provision that could lead to the holder losing principal or interest c) Ability for borrower to prepay or lender to insist on repayment not contingent on future events d) No conditional returns or repayment provisions other than as per a) or c)
1. Examples of basic financial instruments Trade debtors Loans from subsidiaries repayable on demand Debt instrument that would be repayable if there was a covenant breach
1. Examples of financial instruments that are not basic An interest rate swap that returns a cash flow that is positive or negative An option
1. Main accounting changes on financial instruments Basic If not a financing transaction, then initially recognise at transaction price If a financing transaction, then recognise at present value of the future payments discounted at a market rate of interest for a similar instrument
1. Financial instruments Eg. Loan of 10m at 10% interest rate (the then market rate) Current market rate 5% Agree with bank a new loan of 20m at 7½%
1. Financial instruments Accounting entries Derecognise existing 10m loan Recognise new 20m loan at PV of future payments discounted by 5% Assuming annual interest payment and 20 year loan: NPV is 26,231k
1. Financial instruments Before k After k Cash 10,000 20,000 Loans (10,000) (26,231) - (6,231) I&E - (6,231) (loss)
1. Financial instruments Basic: subsequent measurement Amortised cost except publicly traded shares (usually benign)
1. Financial instruments Other Initial measurement: fair value (not including transaction costs) Subsequent measurement: fair value (minor exceptions) Changes in income and expenditure account (unless hedge accounting applies) Highly complex rules and documentation required
1. Financial instruments Other Some loans will fail hedge accounting criteria (eg. RPI linked instruments) May need to opt up for full IAS 39/IFRS 9
1. Financial instruments Other Eg: Loan 10m paying 3 month LIBOR plus 100 bp: 20 year life bullet repayment No issue costs Stand alone swap: same period and matched cash flows, Overall effect: 6% fixed
1. Financial instruments At inception of the swap: Fair value nil (presumably) Loan 10m At next reporting date: Fair value of swap 1m in the money (Assume no hedge accounting)
1. Financial instruments Loan is a basic instrument: Therefore still a 10m liability Swap: 1m asset Cr: Interest receivable 1m
1. Financial instruments At second reporting date: Fair value swap is say 1m out of the money (still no hedge accounting) Loan still at 10m Swap: now a 1m liability Dr: Interest payable 2m
1. Financial instruments What if the swap was embedded?: Answer: Loan (including the swap) is a basic instrument and therefore at amortised cost i.e. 10m No I&E account effect
2. Hedge accounting Overview When it can be applied Examples Pitfalls
2. Hedge accounting overview If accounting for financial instruments is horribly complex, hedge accounting is even worse
2. Hedge accounting overview Normally, movements in fair value of financial instruments go through the income and expenditure account; hedge accounting permits the gain or loss on the hedging instrument and on the hedge item to be recognised in the I&E account at the same time In practice this means movements posted directly to reserves (in most cases)
2. Hedge accounting overview However There are strict conditions for when it can be applied Effectiveness testing has to be performed (prospective)
2. Hedge accounting overview Text in grey potentially to change when IFRS 9 is finalised and EU adopted Entities can opt to apply the recognition and measurement provisions of IAS 39 (ie. full IFRS) instead of sections 11 and 12 of FRS 102
2. Hedge accounting when it can be applied Clear designation and documentation Hedging instrument is expected to be highly effective in offsetting the designated hedged risk The hedged risk is a permitted risk (next slide) The hedging instrument is a permitted instrument (next slide after that)
2. Permitted risks for hedge accounting (main areas) Either Interest rate risk of a debt instrument measured at amortised cost Or Foreign exchange or interest rate risk in a firm commitment or a highly probable forecast transaction
2. Permitted instruments for hedge accounting Needs to meet all of the following: Interest rate swap, a foreign currency swap or a foreign currency forward exchange contract A party external to the reporting entity Notional amount equal to the designated amount of the hedged item Maturity not later than the hedged item No prepayment, early termination or extension features
2. Cease to apply hedge accounting if Hedging instrument expires or is sold Conditions no longer met The entity revokes the designation
2. Examples: first question Floating rate loan (3m LIBOR) 10m 25 years left; qualified as basic instrument and held at amortised cost 5 year swap (1m LIBOR) 5m nominal Designated as hedge
2. Examples: answer Provided it passes the effectiveness test, hedge accounting should be applied on 5m of the loan
2. Examples: second question Same as above but loan has only 4 years left to run
2. Examples: answer Not eligible for hedge accounting (swap expires after hedged item)
2. Examples: third question Same as above but loan has a feature which makes it other and therefore accounted for at fair value. Hedge is highly effective
2. Examples: answer Not eligible for hedge accounting (hedged item is not at amortised cost)
2. Examples: fourth question Same as first but only documented the designation as a hedge on 1 October (March year end)
2. Examples: answer First six months not eligible, but is eligible from 1 October onwards
3. IFRS 9 Intention that new UK GAAP will be revised once (if!) IFRS 9 is finalised and amended to be based on IFRS 9
3. IFRS 9 Approximate sequence but subject to change: Various bits about to go on consultation, other bits still to be drafted Published timetable states for accounting periods starting 1 January 2015 EU not even looking at until issued in final form FRS 102 to be updated? SORP to be updated? Cows come home?
3. IFRS 9 Presently hedge accounting rules are a long way from being finalised Likely to be simple and based more on the way in which treasury risks are managed
3. IFRS 9 However will almost certainly have unintended consequences and lead to some instruments being treated in a worse manner Not a panacea, not able to comment conclusively
4. Challenges Increasing familiarity with highly complex accounting rules Requirements not yet finalised Assessing full portfolio of loans and other instruments for risks on financial reporting Choosing advisors carefully
5. Pensions accounting: Summary of changes DC schemes: no change DB schemes: similar principles but interest calculated using discount rate on net balance whereas FRS 17 requires interest on assets to be calculated using investment return and liabilities using discount rate
5. Pensions accounting: Summary of changes: Interest calculation E.g. Scheme information Amount Return/discount Assets 10m 8% Liabilities 20m 4% Interest calculation FRS 17 Net liability 10m Interest charge nil FRED48 Net liability 10m Interest charge 400k
5. Pensions accounting: Multi employer schemes E.g. SHPS FRED48 (amendment) requires the liability to be recognised for a contractual agreement to fund the deficit if due in more than one year then discount if less than one year recognise in full prior year adjustment in 1 st year of adoption: Impact on reserves not I&E when amounts are revised there will be an I&E impact for the full increase
5. Pensions accounting: Multi employer schemes (continued) FRS 17 exemption (currently) FRS 17 is no longer proposed to be amended
5. Pensions example An Association has obligations in respect of past service to pay to SHPS various amounts over a number of years. The NPV of these payments at 1 April 2014 is 1m, using a discount rate of 5% (the rate applicable at that time). It is a March year end and the Association had not previously recognised this liability. Payments in 2015 and 2016 will be 120,000 and 140,000 respectively
5. Pensions example 1 April 2014: prior year adjustment Dr Reserves 1,000 Cr Creditors (1,000) k Year ended 31 March 2015 k Dr I&E account 50 Dr Creditors 70 Cr Cash (120)
5. Pensions example Year ended 31 March 2016 k Dr I&E account 46.5 Dr Creditors 93.5 Cr Cash (140)
5. Pensions example During the year ended 31 March 2017, SHPS announces a new funding obligation in respect of past service of an additional NPV of 400,000
5. Pensions example In addition to a similar entry to the ones already described, we then have Dr I&E account 400 Cr Creditors (400) k So quite an impact in the year any additional contributions are agreed