This article is not a light read. Before starting, we strongly recommend you take a deep breath and be prepared to need to read it more than once. Unfortunately, it is only an amuse-bouche in what might be described as a full seven course banquet awaiting you from the delights of accounting for financial instruments once the draft FRSME comes into effect. In fact, a more appropriate analogy might be that it represents a single crumb left over from the meal enjoyed by the previous patrons.
There is a huge amount of change coming to the sector as the previous article on the future of RP reporting stated. However, the most challenging area is undoubtedly the accounting for financial instruments. This article comments on only one specific part of the proposed changes: how to decide whether a financial instrument is categorised as 'basic' or 'other'.
If it is 'basic', it will fall within the relatively straightforward environment set out in section 11 of the draft FRSME. However, if it is 'other', it will need to be accounted for in the much more challenging environment within section 12. This matters because (with a few exceptions) if a financial instrument falls within section 12, the normal accounting treatment will be to record it at fair value at each period end. This could potentially result in huge volatility. Although in some cases there may be steps an entity can take to mitigate the effect, for example by establishing hedge accounting, these are also very complex and can easily fail because one or more of the detailed requirements are not adequately met. Some particular instruments in place within the sector are unlikely to ever be able to meet the hedge accounting requirements, suggesting that either the affected association will need to break the instrument before the changes come into effect, establish another method of limiting the volatility (e.g. entering into a similar but opposite financial instrument) or accept the volatility.
The current accounting process that we are familiar with is largely benign in that most financial instruments are recorded at either the lower of cost and net realisable value (if they are an asset), or the level of net proceeds from the instrument with issue costs, such as arrangement fees, amortised over the life of the instrument (if they are a liability).
Under the current proposals within the draft FRSME, although the logic is different, in practice most 'basic' financial instruments are treated in much the same way as they have been in the past. However, there will be exceptions, for example suppose an association provides an interest-free loan to a subsidiary. This will be recorded initially at the present value of future payments discounted at a market rate of interest for a similar debt instrument. It will therefore be recorded at a lower figure than the amount lent, resulting in a gain in the subsidiary and a loss in the association.
More complex financial instruments are also treated very differently from current practice. Furthermore, quite a few instruments that at present we would regard as not that complicated are nevertheless classified as 'other financial instruments' and therefore fall within this more challenging accounting section.
The decision over whether something is 'basic' or 'other' is based on rules spelt out in the draft FRSME. They specify that if the instrument meets the tests, it is 'basic', however, if it does not, then it is 'other'. The definition does not seem to permit any judgement or flexibility. The tests are that the financial instrument needs to be in one of the following four categories:
- a debt instrument that meets certain conditions (see below)
- a commitment to receive a loan that meets these same conditions and in addition cannot be settled net in cash
- an investment in shares that are both non-convertible and non-puttable.
The conditions that need to be met for a debt instrument or commitment to receive a loan to be classified as 'basic' are as follows.
- The return to the holder (e.g. a lender or bond holder) must be either a fixed amount, a fixed rate of return over the life of the instrument, a variable rate that is equal to a single referenced quoted or observable interest rate (such as the London interbank offered rate (LIBOR)) or some combination of these rates provided that they are all positive.
- There is no contractual provision that could result in the holder losing principal or interest.
- Any contractual provision permitting the borrower to prepay or permitting the issuer to request early payment are not contingent on future events.
- There are no conditional returns or repayment provisions except for the variable rates or prepayment provisions as discussed.
At first glance, these may seem reasonable definitions. However, there are many examples of financial instruments in place within the sector which will not meet these definitions and will therefore be classified as 'other'. Here are a few illustrative examples:
- a loan which includes a clause that enables the lender to request repayment if the applicable taxation or accounting requirements change (fails (c))
- an option, unless it is embedded within another financial instrument and the combination meets the tests specified above (fails (a))
- an inter-company loan to a subsidiary which has net liabilities, or is otherwise reliant on intra-group support to meet its obligations and in relation to which the lender and borrower have agreed that parts of the balances will be waived in the event that the subsidiary is unable otherwise to meet its obligations as they fall due (fails (b))
- a loan in which part of the interest charged is linked to RPI (fails (a)).
However, there are many more types of financial instrument that will not pass this test.
Our advice is for each association to summarise the financial instruments it has in place and then assess which may fall into the 'other' category. You will then need to consider carefully what the accounting treatment will be and whether this is potentially damaging to the association.
We will be writing further articles on this subject in the future but professional advice is almost certainly going to be wise, even if you think your financial instruments only fall into the 'basic' category.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.