Discussion Paper on Financial Instruments

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• Discussion Paper on Financial Instruments

2
Project history

• ASB work methods ? need for new guidance
• Discussion Paper
• Consultation ? 3 project groups Preparers,
  auditors, users (3 spheres)
• Consultation with key stakeholders ? NT, SARS,
  prof bodies, members of the APC

3
Project timeline
Under-construction
Comment process
DP
Comment process
ED
Standard
End July/Aug
Early/Mid 2009
End Feb
End 2008
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Development basis

• IAS 32, 39 IFRS 7
• CIPFA SORP
• CICA PSAB - ED

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What are financial instruments?
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What is a financial instrument?
Entity B
Entity A
Contractual arrangement
Financial asset
Financial liability or equity instrument
Cash Equity instrument Contractual right to
receive cash or exchange FI (fav)
Contractual obligation to deliver cash or
exchange FI (unfav)
Evidences res int in NA
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Key features

• Contractual arrangement
• Settlement in cash or FA or FL, not GS
• Timing and amount certain

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Application

• Sales of goods services
• - for cash
• - for credit
• Staff loans granted
• Deposits with bank
• Money market investments
• Property, plant equipment

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Application

• Bonds acquired
• Investment in equities or similar instrument
  (e.g. Telkom)
• Prepaid expenditure
• Creditors (e.g. water, electricity)
• Accruals/provisions
• Revenue received in advance
• Loans from financial institutions

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Application

• Finance leases
• Post retirement benefits
• Preference shares issued
• Perpetual debt issued
• Receivables re fines taxes
• Transfer payments to be made

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Fundamental issues

• Contract
• Compulsory transactions

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Contract in the PS?

• Should this be binding arrangement in the
  public sector?
• Contract traditional FI
• Legislation compulsory, legislative FI
• Operation of law

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Compulsory transactions

• Financial instruments measured at fair value
  initially
• FV implies willing buyer willing seller
• Can forced transactions ever be measured at FV?
• Interaction NXR FI

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What are the options?

• Option 1 amend the definition of a FI ? binding
  arrangement not contract
• Option 2 amend the scope only ? def still
  contract
• Option 3 develop separate guidance on
  non-contractual (non-exchange?) monetary
  instruments

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Some basic definitions scope exclusions
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Proposed definitions

• Financial asset
• Financial liability
• Equity instrument

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Proposed definitions
Excluded share based-payments

• Financial asset
• Cash
• Equity instrument or residual interest in another
  entity
• Right under a binding/contractual arrangement
  to
• - receive cash or FA
• - exchange FA FL under fav conditions

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Proposed definitions

• Financial liability
• Obligation under a binding/contractual
  arrangement to
• -deliver cash or FA
• -exchange FA FL under unfav conditions

Excluded share based-payments
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Proposed definitions

• Equity instrument
• Contract that evidences a residual interest in
  the assets of an entity after deducting all of
  its liabilities

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Scope

• Investments in CE, JV, Associates, where carried
  _at_ cost in separate financial statements
• RO under DBP - Employee benefits
• Lease receivables payables Impair
  derecognition embedded derivatives
• Insurance contracts, except guarantees
• Re-imbursements under GRAP 19

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Scope

• Own equity instruments
• Contingent consideration in entity combination
• Contracts between acquiror and acquiree to
  acquire an entity at a future date
• Social benefits
• Estimates of revenues

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When do I recognise FI on my PER?
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Issues re recognition

• At what point do I recognise FI?
• -Contractual provisions,
• - Trade v settlement date accounting
• Who recognises FI (Agency relationships)
• What am I going to recognise (A, L, CFO)
• - Substance over legal form
• - Compound FI

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When do I recognise?

• In terms of the contractual provisions
  provisions of the binding arrangement of the
  instrument
• Regular way purchases and sales of FI ?Trade
  versus settlement date accounting

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Provisions of contract or BA

• Clear economic consequences
• No realistic alternative but to settle.
• Examples Bonds traded in a market, debtors for
  services provided, taxes

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Regular way purchases sales

• Either trade or settlement date accounting
• Impact where instruments subsequently measured _at_
  fair value
• Simplification trade date, wider use as can be
  used for derivatives
• Decision in line with what other countries have
  done in the PS (Canada UK local)

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Who recognises Agency relationships

• Who accounts for transactions - Agent or
  principal?
• Broader issue than just financial instruments
  revenue debtor linked
• No authoritative guidance currently in GRAP
• Indicators from FASB guidance (EITF 99-19)

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Agency relationships

• Approach in FI DP
• Framework re control, access to FEB
• Indicators
• -Primary obligor (Who must perform?)
• -Who can establish price?
• -Who determines nature, type, specs of products?
• -Who bears credit risk?

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What do I recognise?

• Equity versus liabilities
• Substance over legal form
• -Liability obligation to repay or pay returns
• -Equity no obligation to repay, managements
  discretion, evidences residual interest in net
  assets

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What do I recognise?

• Examples
• Preference shares, redeemed in 10 years, fixed
  coupon 10 p.a.
• Perpetual bonds

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What do I recognise

• Compound financial instruments
• Separate into equity and liability component
• Calculate liability, allocate to CV first
• Equity residual
• Sum cannot exceed FV, no G/L to be recognised

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Compound instruments

• Non-derivatives that contain both an equity and a
  liability component split out each element
• FV of Instrument Liability Equity
• EG An entity issues 2,000 convertible bonds at
  the start of year 1, with the following
• Each bond can be converted into 250 ordinary
  shares,
• Three year term,
• Face value of R1,000 per bond,
• Interest rate of 6 payable annually in arrears,
• Market rate for similar bond is 9.

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Compound instruments
Calculation
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Compound instruments
Calculation
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What do I recognise?

• What is the nature of those liabilities that are
  in substance equity rather than liabilities?
• -Net assets CFOReserves
• -Transactions with entities, not owners,
  entitled to limited interest in net assets

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How do I value FI?
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Broad criteria

• Different from other exchange standards
• Initial measurement _at_ fair value
• Fair value
• - Willing buyer, willing seller
• - Arms length transaction
• Usually transaction price
• Need to consider whether or not price includes
  something other than the financial instrument

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FV differs at initial recognition

• Examples
• Deep discount zero coupon bonds
• No or low interest loans
• Credit periods granted AL perspective

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Fair value _at_ initial recognition

• Example
• Sale made to a customer for R100, will be settled
  in one year no interest charged.
• Market related interest is 10
• On initial recognition
• Dr Debtor R95
• Cr Revenue R95

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Fair value _at_ initial recognition

• Example
• End of year
• Dr Debtor R5
• Cr Interest R5
• Cash received
• Dr Bank R100
• Cr Debtor R100

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FV at initial recognition

• Credit periods
• What is deemed to be extended payment terms?
• How are principles different in the DP to private
  sector standards, why?
• Is it different for transfer payments for
  example?
• What is a market related rate for determining
  interest re credit periods?

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FV at initial recognition
Extended credit - IFRIC
DP
1 to 31 March
2 April
30 April
25 May
Provision of goods services
Statement issued
Due date for payment
Receipt of cash
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Interaction with other Standards
What if another Standard of GRAP provides initial
measurement principles? EG Leases Taxes?
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Interaction other standards
Non-exchange transactions
ED 38
Financial instruments
ED 38
Init. meas
Subs. meas
De-recogn.
Present.
Disclosures
Recognise
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Interaction other standards
Leases
Financial instruments
GRAP 13
GRAP 13
Init. meas
Subs. meas
De-recogn.
Present.
Disclosures
Recognise
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Market related rate

• Rate that reflects period, credit quality and
  risk associated with instrument, in market
• Is this appropriate for all types of instruments?

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Market related rate

• Compulsory transactions - rate
• Legislated rate
• Governments WACC
• Government bond rate, same maturity, adjusted for
  risk
• Entity WACD/WACC adjusted for risk
• Repo rate margin
• Prime lending rate
• Is it appropriate to use different rates for
  different types of transactions?

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Concessionary loans

• Loans granted to entities/individuals
• Public policy purposes
• Concessionary terms low or no interest
• Flexible repayment terms
• Initial recognition
• - PV of Outflows-PV of Inflows subsidy cost
• - Using market related rate

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Financial guarantees

• Def
• Contract
• Requires issuer to make specified payments to
  reimburse holder for a loss
• Debtor fails to make payment when due in in
  accordance with original or modified debt
  instrument
• Removed option to treat as insurance cont

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Financial guarantees
Issuer
Debtor to financier
Guarantee fee
Default
Repayment of debt
Issue guarantee to financier on behalf of debtor
Financier
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Financial guarantees

• Initial recognition - FV of consideration
  received
• What do you do where no consideration received?
• Differential in borrowing cost of debtor
• Fee charged by a similar institution
• Cost v benefit ? carry at expected loss amt

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Value of FI every year?
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Subsequent measurement

• IAS 39 Categorisation of FA FL drives
  subsequent measurement
• 4 categories of FA, 2 FL
• IFRS for SMEs
• Other countries

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(No Transcript)
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Subsequent measurement

• Measure FA FL at amortised cost/cost, except
  for those carried at FV
• FV gains/loss in SD
• No G/L through equity

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Subsequent measurement
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Subsequent measurement

• Can elect to carry certain items that have quoted
  prices _at_ amrt cost ? fixed determinable
  payments
• - Must disclose FV
• Reclassification of instruments
• - Amrt cost ? to FV, not other way unless
• - FV no longer determinable
• Views on deleting alternative accounting
  treatment re inv in CE, JV, Ass?

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Subsequent measurement

• Measurement issues
• Amortised cost
• Fair value
• Treatment of transaction costs
• Impairment of FA
• Specific considerations
• Concessionary loans
• Guarantees

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Subsequent measurement

• Amortised cost
• Initial measurement
• (Consideration Trans costs)
• Minus Principal repayments
• Plus/minus Amortisation (eff i-rate)
• Minus Impairment
• Effective rate Exactly discounts CF to PV

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Impairment of financial assets

• Assess at each reporting date
• PV of CF versus CV ? using original interest rate
• Objective evidence of impairment
• Direct impairment or use of allowance account
• Measure impairment before negotiations with
  counterparty

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Observable evidence

• Loss event
• Significant financial difficulty of issuer
• Breach of contract e.g. delinquent interest or
  capital repayments
• Probable borrower will enter bankruptcy or
  financial re-organisation
• Disappearance of an active market (financial
  difficulties)
• Observable data that measurable decrease in
  estimated future cash flows
• - adverse change in payment status
• - national/local economic conditions correlate
  to default

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Impairment of FA _at_ AMRT cost

• Individually significant test
• If individually not impaired include in group
• If individually impaired do not include in
  group.
• Smaller items can either be tested individually
  or as a group

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Impairment of FA _at_ AMRT cost

• Group based on similar risk characteristics
  (asset type, geographical location, past due
  status, counterparty)
• Group based on credit risk re ability to pay
• Assess impairment for group eventually allocate
  impairment to individual

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Impairment of FA _at_ AMRT cost

• Once impaired interest charged based on
  discount rate
• Model take into account TVM, unless immaterial

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Impairment of FA _at_ cost

• CV v FV, or
• PV using market related rate

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Impairment of financial assets
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Subsequent measurement

• Fair value
• Initial measurement
• (Consideration Trans costs)
• Plus/minus Changes in valuation

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Subsequent measurement

• Fair value
• Active market
• Quoted price, bid/ask price
• When no bid/ask Most recent transaction
• If most recent price inappropriate adjust
• If only prices for components available, value

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Subsequent measurement

• Fair value
• No active market
• Discounted cash flow or option pricing
• TVM
• Credit risk
• Forex risk
• Commodity prices
• Equity prices
• Volatility

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Concessionary loans

• Probably amortised cost (fixed determinable
  payments?)
• Subsidy cost (Excess of PV of outflows PV of
  inflows)
• - Amortised over period, effective interest rate
  method

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Financial guarantees

• Higher of
• Amount initially recognised less amortisation
  and
• Expected loss (GRAP 19)

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When do I remove FI from by PER?
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Derecognition of FA
Consolidate all SPEs
Should this apply to all or part of an asset
Y
Rights to CF expired?
Derecognise
N
Transferred right to receive cash?
N
N
Obligation to pay cash flows?
Do nothing
Y
Transferred subs all R R?
Y
Derecognise
N
Y
Retained subs all RR?
Do nothing
Y
N
Retained control?
Derecognise
Y
Continue to recognise, based on continuing
involvement
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Derecognition - FL

• Obligation discharged
• FL exchanged terms substantially different
• Terms of existing debt substantially modified
  (10 variation in PV of new old)

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What do I show in the FS?
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Presentation

• Transaction costs
• Gains, losses, dividends, interest received and
  paid
• In surplus or deficit
• Dividends paid in St of CAN
• Offsetting
• Only when legally enforceable right and
• Intend to settle net
• Treasury shares
• SCNA G/L

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Disclosures

• CA of categories of FA and FL
• Basis for determining FV
• If no FV for equity instrument, disclose fact
• Reclassifications
• CV of FA pledged as collateral
• FV of collateral held by entity, plus whether or
  not sufficient to cover debt
• Recon of allowance account
• Defaults on loans payable by the entity loans
  in default at year end

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Disclosures

• Net gain or loss on each category of financial
  asset/financial liability
• Interest received and paid for amrt cost
• Interest on impaired loans
• Impairment losses for each category of financial
  asset
• Accounting policies re FI
• Types of risks entities exposed to, how they
  arise, objectives, policies and processes for
  managing risk, methods of measuring risk

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Disclosures

• Credit risk
• Maximum exposure to credit risk for each
  category
• Description of collateral held
• Credit quality of instruments not impaired or
  past due
• CA of FA past due or impaired whose terms have
  been renegotiated
• Age of FA past due but not impaired
• Analysis of individually significant debtors
  factors used to determine that impaired

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Disclosures

• Liquidity risk
• Maturity analysis for FL showing remaining
  contractual maturities
• Market risk
• Disclosure of FV of FA FL encouraged
• No market sensitivity, only disclose significant
  assumptions and terms of agreements

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Disclosures

• Liquidity risk
• Maturity analysis for FL showing remaining
  contractual maturities
• Market risk
• Disclosure of FV of FA FL encouraged
• No market sensitivity, only disclose significant
  assumptions and terms of agreements

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Other matters
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Other matters

• Derivatives (Subs meas)
• Embedded derivatives (Separation or _at_ FV)
• Hedge accounting (no hedge acc ? IAS 39)

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Derivatives

• FI or other contract within the scope of FI
• All 3 characteristics
• - Value changes in response to interest rate, FI
  price, commondity, forex rate, index, credit
  rating, non-fin variable (not specifically
  related to contract)
• - No or little initial investment
• - Settled at a future date

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Derivatives

• Typical examples
• Forward exchange contract (FEC)
• Option

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Derivatives

• Example
• Bought machinery from overseas, GBP 100,000 on 30
  Nov 07
• Took out FEC on same day
• Year end 31 March 08
• Pay creditor 31 May 2008

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Derivatives

• Rates
• Spot
• - 30 Nov R15,00 GBP
• - 31 Mar R16,00 GBP
• - 31 May R17,00 GBP
• FEC rate
• - 30 Nov R14,50 GBP
• - 31 Mar R16,50 GBP
• - 31 May R 18,00 GBP

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Derivatives

• 30 November
• Dr Equipment 1,500,000
• Cr Creditors 1,500,000
• 31 March
• Dr FEC Asset 200,000
• Cr Gain 200,000
• Dr Forex loss 100,00
• Cr Creditors 100,00

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Derivatives

• 31 May
• Close out FEC
• Dr FEC Asset 50,000
• Cr Gain 50,000
• Dr Cash 250,000
• Cr FEC Asset 250,000
• Settle creditor
• Dr Creditor 1,700,000
• Cr Bank 1,700,000

90
Embedded derivatives

• Component of a hybrid instrument
• Include a non-derivative host contract
• CFlows of combined instrument vary in a way
  similar to a stand-alone derivative.
• Change in response to i-rate, credit index,
  commodity price, forex rate.

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Embedded derivatives

• If host contract in the scope of FI, designate at
  FV
• If host not in scope of FI e.g. leases ? separate

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Embedded derivatives What to do?

• Separate from host contract and accounted for as
  a derivative, if
• Economic characteristics not closely related to
  economic charact. risks of host contract
• Separate instrument with the same terms as ED
  meets the definition of a derivative.

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Embedded derivatives What to do?
Would it be a derivative if freestanding?
Is it closely related to the host contract?
Split
Yes
No
No
Yes
Do not split out the embedded derivative
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Embedded derivatives

• When are economic characteristics closely
  related to host contract
• Floor or cap where the cap is above and floor is
  below market rate (out of the money)
• Foreign currency derivative in a host contract
  that is an insurance contract or non FI (as long
  as not leveraged, no option feature) and requires
  payment in
• - Functional currency of any substantial party
• - Currency in which price of good or service
  routinely denominated
• - Currency used to buy/sell non-financial items
  in economic environment where tx takes place.
• CPI linked payments in a lease (own country),
  contingent rents, etc.

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Embedded derivatives

• Examples
• 10 yr lease of a building, rental payments
  determined contractually
• Rental payments increase by annual inflation
  linked with reference to CPI in SA
• Rental payments increase linked to property
  price index
• Rental payments increase at 3XCPI
• Rental payments increase at 2 p.a.

96
Embedded derivatives

• Examples
• Contract to construct a road, and will take 3
  years to complete. The contract payments will
  increase based on
• Wages CPIX
• Materials 4

97
Embedded derivatives

• Examples
• Loan granted by a financial institution that
  bears interest at a variable rate determined by
  reference to
• the prime lending rate
• increase on the ALSI

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Disclaimer

• The views expressed in this presentation are
  those of the individual. Official positions of
  the ASB on accounting matters are determined only
  after extensive due process and deliberation.