FRS 23, 25, 26 and all that !

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FRS 23, 25, 26 and all that !

• John Clacy
• 19th October 2006

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(No Transcript)
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Agenda

• How are your funds effected?
• So what?
• Valuation of portfolios
• Functional currencies
• Transactional costs
• Accounting for shareholders equity
• Cashflow vs. FV hedge
• Effective interest rate accounting
• Segmental report
• Other points
• Questions

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How are investment funds impacted by IFRS/FRS 23,
2526?

• Most are affected in some way
• IFRS v Non IFRS Various considerations but..
• UK GAAP convergence
• EU incorporated, listed funds with subsidiaries -
  as listed groups, need to adopt IFRS directly as
  a consolidated group under EU law for accounting
  periods commencing on or after 1 January 2005.
• EU Listed single company funds (i.e. NOT CISX) -
  as listed companies, need to adopt FRS 23 (IAS
  21) FRS 25 (IAS 32) and FRS 26 (IAS 39) as
  converged UK GAAP for listed companies for
  accounting periods commencing on or after 1
  January 2005.
• Unit trusts/OEICs/Other funds - as unlisted
  entities, need to adopt FRS 25 (presentation)
  (IAS 32) from 1 January 2005. FRS 23, 25
  (disclosure) and 26 does not, as currently
  drafted, appear to include unit
  trusts/OEICs/other funds within its scope.
• albeit through different routes and different
  timescales.

Listed
Not Listed
FRS 25 (IAS 32)
FRS 23, 2526 (IAS 32/39)
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Valuation of portfolios (FRS 26/IAS39)
Instrument classification Measurement Interest income using effective interest method Fair value changes FX ? Impairment test?
Fair value through profit and loss Fair Value Required where interest income disclosed separately Yes PL FX and investment in one line through PL No
Held to maturity Amortised cost Yes No No FX adjustment Yes
Loans and receivables Amortised cost Yes No No FX adjustment Yes
Available for sale Fair value (except where fair value cannot be determined) Yes Yes-Equity FX separately through PL Yes
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Valuation of portfolios (FRS 26/IAS 39)

• Most seem minded to choose fair value through
  profit and loss account (FVTPL) as designation
  for investment portfolio.
• Either held for trading or designate but need to
  hit further criteria including
• a group of financial assets, financial
  liabilities or both is managed and its
  performance is evaluated on a fair value basis,
  in accordance with a documented risk management
  or investment strategy, and information about the
  group is provided internally on that basis to the
  entity's key management personnel.
• Need to consider liabilities/gearing and their
  designation.
• Fund administrators generally seem comfortable
  with move to bid pricing (or last trade in
  certain overseas markets).
• If FVTPL is the designation, transaction costs
  must be expensed rather than capitalised.
• Question of whether mark down to bid after
  purchase at offer is a transaction cost rather
  than unrealised loss? Consensus - not a
  transaction cost.
• If AFS is selected as designation, foreign
  exchange and market movements must be separated.
  Foreign exchange movements go to the Profit
  Loss/Income Statement
• Cannot alternate account under FRS26, e.g. with
  profit policies.

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Retail funds - Valuation of portfolios (continued)

• Derivatives raise their head too
• Geared funds with interest rate swaps will need
  to FV on balance sheet and take movements to PL
  unless steps to designate, document and measure
  effectiveness are implemented. (i.e. hedge
  accounting).
• Certain instruments may be considered embedded
  derivatives (e.g. index linked loan stock), and
  require debt and equity components to be split
  and measured separately, with equity portion FV.
  
• these are just highlights

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Functional currencies

• New concept possible difference between
  functional (in which you record transactions) and
  presentational currency (in which you present
  financial statements)
• IAS 21 sets out requirements. UK GAAP has
  converged (only where entities are applying FRS
  26 (FRS 23)).
• Series of indicators to be considered when
  determining functional currency.
• Where indicators are mixed, directors judgement
  required to determine appropriate functional
  currency.
• However, guidance in place in terms of
  appropriate priority to be given to different
  indicators, means it is not a free choice.
• some funds may need to change functional
  currency.

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Functional currencies

• Exchange gains and losses
• Exchange differences between functional and other
  currency taken to profit and loss account.
  Exchange differences between functional and
  presentational currency if different taken to
  equity.
• Series of indicators to be considered when
  determining functional currency
• Primary economic environment of operations in
  which it generates expends cash.
• Currency in which financing activities are
  denominated (debt and equity issues).
• Currency in which receipts from operating
  activities are usually retained.
• e.g. Fund, equity and gearing in sterling, but
  all investments in Japanese Yen indicators
  mixed - argument that Yen is the functional
  currency, but fund may choose to present results
  in sterling.
• case-by-case consideration required.
• TALK TO YOUR AUDITORS

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Transaction costs
The standard says Transaction costs are
incremental costs that are directly attributable
to the acquisition, issue or disposal of a
financial asset or financial liability. An
incremental cost is one that would not have been
incurred if the entity had not acquired, issued
or disposed of the financial instrument. What
are transactions costs in respect of investment
funds? Transaction costs include fees and
commissions paid to agents (including employees
acting as selling agents), advisers, brokers and
dealers, levies by regulatory agencies and
securities exchanges, and transfer taxes and
duties. Transaction costs do not include debt
premiums or discounts, financing costs or
internal administrative or holding costs. How
are they accounted? Included in the initial
measurement of financial assets and financial
liabilities other than those at fair value
through profit or loss.
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Transaction costs (continued)

• How should this requirement be applied in
  practice?
• For financial instruments that are measured at
  FVTPL, transaction costs are not added to the
  fair value measurement at initial recognition.
• For available-for-sale financial assets -
  recognised in equity as part of a change in fair
  value at the next remeasurement.
• If an available-for-sale financial asset has
  fixed or determinable payments and does not have
  an indefinite life, the transaction costs are
  amortised to profit or loss using the effective
  interest method. If an available-for-sale
  financial asset does not have fixed or
  determinable payments and has an indefinite life,
  the transaction costs are recognised in profit or
  loss when the asset is derecognised or becomes
  impaired.
• For financial instruments at amortised cost (i.e.
  not at fair value through profit or loss) -
  included in the calculation of amortised cost
  using the effective interest method and, in
  effect, amortised through profit or loss over the
  life of the instrument.
• Materially? TALK TO YOUR AUDITORS!

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Accounting for shareholders equity

• Treatment of Redeemable Preference Shares
• Many non-equity shares, including participating
  redeemable preference shares, will be classified
  as liabilities under IAS 32/FRS 25 and deducted
  from assets in the balance sheet, rather than
  included as part of shareholders funds.
• Implications?
• Net Asset Values
• Income statement treatment of preference share
  dividends as an interest cost rather than
  appropriation from profits
• Debt covenants and shareholder expectations
• Solution?
• The revised IAS32/FRS 25 (within its appendices)
  gives suggested balance sheet and income
  statement formats for unit trusts which show net
  assets and profits before deductions for these
  shares.
• Reversal?
• Exception currently buy looked at!

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Cash Flow vs Fair Value Hedge

• Floating rate debt 5 years _at_ 5 100
• Have a floating to fixed IRS 100 principal 5
  year duration.
• 2. Fixed rate debt 5 years _at_ 5 100
• Have a fixed to floating IRS 100 principal 3
  year duration
• Interest rates go to 10 !!!!
• 1. Debt stays in BS _at_ 100 but also have 50 in
  BS re FV of Hedge. The FV of the
• Hedge taken to equity and released over 5 years.
  It is a cash flow hedge.
• 2. IRS is FVd in the BS at negative 50 and take
  a hit to the Income Ac. The FV of the
• Hedge comes on to the BS by fair valuing the
  debt to 50 and the 50 credit nets off the 50
  loss in the Income Ac.
• What about fixed rate debt? Possible problem as
  likely to be treated at amortised cost which is
  different to 1 above.

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The Effective Interest Method of Calculation
Illustrative examples - Example 1 ABC Fund
Plc Buy a bond of 1/1/2005 with 5 years remaining
to maturity - Fair value cost is
1,000 Nominal/maturity value is 1,250 fixed
interest rate of 4.7 (i.e. 59 per annum)
ABC Fund PLC
Year Amortised cost at beginning of year Interest Income (10) Internal rate of return of cash flows Cash flows Amortised cost at end of the year
2005 1,000 100 59 1,041
2006 1,041 104 59 1,086
2007 1,086 109 59 1,136
2008 1,136 113 59 1,190
2009 1,190 119 1,250 59 0
Source FRS 26 Implementation Guide B.26
Comments The interest rate of 10 is calculated
by taking the cash flows (including the initial
1,000 purchase cost) and calculating the
internal rate of return. Sample Journal Entries
Year 1 Dr Cr Dr. cost of
bond 1,000 Cr. Bank 1,000 For purchase
of bond Dr. cost of bond 41 Dr. Bank
(interest recd) 59 Cr. Interest
Income 100 For year 1 income on bond Within
the financial statements, it is possible to
disclose the amortisation proportion separately
from the interest portion
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The Effective Interest Method of Calculation

• Can be very awkward to calculate and difficult to
  do systematically
• Answer maybe FVTPL as one line / lump but
  possible tax split issues (distribution status
  etc)
• Materiality Call ?
• TALK TO YOUR AUDITORS

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Segmental reporting (IAS only)

• Principles
• IAS 14 applies to listed entities only.
• IAS 14 identified business and geographical
  segments, and requires identification of which
  one is the primary and secondary segment (based
  on dominant source of risks and returns). UK GAAP
  not yet converged.
• Considerably more detail is required to be
  disclosed for primary segments (includes result
  by segment, segment assets and liabilities, and
  reconciliation to the income statement).
• Investment funds
• Argument that these only have one operation
  (investment activities) and therefore may not
  need detailed segmental analysis.
• Alternatively, any segmental analysis (e.g.
  geographic, security type) is likely to
  correspond to fund portfolio data generally
  included in annual reports, so changes will be
  presentational.

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Other matters

• Yes, there is more
• IFRS7/FRS29 other disclosures periods 1 Jan
  07 onwards (FRS 23,25,26 criteria) sensitivity
  analysis is the big gap
• Components, FRS28 (IAS1) need full components??,
  potential set out on s re portfolio statement
  but umbrella funds watch-out!
• Dividends can only be recorded in the period they
  are approved so planning issues and care around
  compliance (IAS 10/FRS21)? Income ?
• Final profit figure will not necessarily equate
  to legally distributable profit
• Tech 21/05 - Distributable profits implications
  of IFRS
• Only Earnings per share figures calculated in
  accordance with FRS 22/IAS 33) may be shown on
  the primary statements others relegated to the
  notes.
• Going concern, issue for limited life funds?
• Impact of Share options provided to service
  providers?
• Netting off, FRS25, right and INTENTION to get
  set off.
• Transitional arrangements, do not need to rework
  comparatives for FRS26 first time around.

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Questions?
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A member firm of Deloitte Touche Tohmatsu