FRS 102: Accounting for basic financial instruments

The term ‘financial instruments’ often results in accountants glazing over. In some cases financial instruments are very complex issues to deal with, but this is not always the case for financial instruments and almost all companies will have some form of financial instrument in their accounts (trade debtors, trade creditors, cash balances and loans are all examples of financial instruments).

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland splits the issue of financial instruments into two sections: Section 11 Basic Financial Instruments and Section 12 Other Financial Instruments Issues.  As financial instruments are a vast area, this is the first in a series of articles looking at financial instruments in recognition that whilst most practitioners won’t have to deal with complex financial instruments, there are some subscribers that will work for clients that deal in such instruments.  This article is written in the context of the revised version of Section 11 published in August 2014.

Whilst Section 11 deals with ‘basic’ financial instruments, the problem is that the section itself is not the easiest of sections to digest as the wording is very complex.

Classification of a financial instrument as ‘basic’

In the broadest terms, a financial instrument is a contract which results in a financial asset arising in one entity and a financial liability arising in another. In other words when one party wishes to raise finance for whatever reason, another party provides that finance.

The section itself gives examples of financial instruments which would normally be accounted for under the provisions in Section 11 as follows:

• cash;
• demand and fixed-term deposits when the entity is the depositor, eg bank accounts;
• commercial paper and commercial bills held;
• accounts, notes and loans receivable and payable;
• bonds and similar debt instruments;
• investments in non-convertible preference shares and non-puttable ordinary and preference shares; and
• commitments to receive a loan and commitments to make a loan to another entity that meets the conditions of paragraph 11.8(c).

The paragraph then goes on to identify those instruments which would not normally satisfy the conditions in paragraph 11.8 and hence would be accounted for under Section 12 which would include:

• asset-backed securities, such as collateralised mortgage obligations, repurchase agreements and securitised packages of receivables;
• options, rights, warrants, futures contracts, forward contracts and interest rate swaps that can be settled in cash or by exchanging another financial instrument;
• financial instruments that qualify and are designated as hedging instruments in accordance with the requirements in Section 12; and
• commitments to make a loan to another entity and commitments to receive a loan, if the commitment can be settled net in cash.

In order to determine whether a financial instrument is ‘basic’ (ie falls under the scope of Section 11) or ‘not basic’ (ie is then accounted for under Section 12) it is necessary to look to the conditions in paragraph 11.8 of FRS 102. This paragraph says that an entity shall account for the following financial instruments as basic financial instruments in accordance with Section 11:

• Cash;
• A debt instrument (such as an account, note, or loan receivable or payable) that meets the conditions in paragraph 11.9 and is not a financial instrument described in paragraph 11.6(b);
• Commitments to receive or make a loan to another entity that cannot be settled net in cash and when the commitment is executed, are expected to meet the conditions in paragraph 11.9; and
• An investment in non-convertible preference shares and non-puttable ordinary shares or preference shares.

The problems begin to emerge when it comes to (b) above; although the reality is that the conditions might only need to be consulted in complex situations because in practice it would be fairly obvious whether a debt instrument is ‘basic’ or ‘complex’. However, the following conditions must be met in order for a debt instrument to fall to be classed as ‘basic’. There is a ‘health warning’ here – these conditions are not the easiest to understand and, wherever possible, paraphrasing has occurred to try and convey what the official standard is requiring.

Condition (a) Return to the holder (the lender)

The return which the holder (ie the lender) receives must be:

• a fixed amount;
• a positive fixed rate of return, or a positive variable rate of return; or
• a combination of a positive, or negative, fixed rate and a positive variable rate.

In respect of (iii) above, paragraph 11.9 cites an example of LIBOR plus 200 basis points or LIBOR less 50 basis points, but not 500 basis points less LIBOR.

Sub-condition (aA) Contractual provisions

The contract may contain provisions for repayments of the capital amount, or the return the lender receives (but not both) to be linked to a single relevant observable index of general price inflation of the currency in which the debt instrument is denominated, provided such links are not leveraged.

Sub-condition (aB) Determinable variation of the return to the holder

The contract may contain provisions for a determinable variation of the return to the lender during the life of the instrument, provided that:

• The new rate satisfies condition (a) [ie the return to the lender above] and the variation is not contingent on future events other than a change of a contractual variable rate; to protect the lender against credit deterioration of the borrower; and changes in levies applied by a central bank or arising from changes in relevant taxation or law; or
• The new rate is a market rate of interest and satisfies condition (a) [ie the return to the lender above].

If the contract enables the lender a unilateral option to change the terms of the contract then these are not determinable for this purpose.

Condition (b) Contract contains no detrimental provisions

The contract must not make any provisions which would result in the lender losing out on any amount of capital or interest attributable to the current or prior periods. If any class of debt is subordinate to other classes then this would not be an example of such a provision because the subordinate class would still be treated as a debt instrument.

Condition (c) Contractual provisions which are beneficial to the lender

Where a contract allows the borrower to prepay a debt instrument, or the contract allows the lender to put it back to the borrower before maturity, then these conditions should not be contingent on future events. This can be overridden in certain situations, for example to protect:

• the lender against credit deterioration of the borrower (such as defaults, reduction in credit-rating or violations in loan covenants) or a change in control of the borrower; or
• the lender or borrower against changes in levies that are applied by a central bank or which arise due to changes in legislation (including tax legislation).

Example – early repayment

Company A enters into a contract with Company B to borrow funds from Company A for a 10-year period. The contract makes provision that in the event of early termination, Company B will compensate Company A for the early termination.

Where a contract makes provisions for early termination, this will not result in a breach of this condition.

Condition (d) Extension of contractual terms

Provisions may exist within a contract which allow the term of the debt instrument to be extended. When this happens, any return to the lender and any other contractual provisions which apply during the extended term must satisfy the conditions in (a) to (c) above.

The revised Section 11 contains some examples of debt instruments showing how certain debt instruments may, or may not, meet the complicated provisions in paragraph 11.9. A couple of these examples are:

A fixed interest rate loan with an initial tie-in period which reverts to the bank’s standard variable interest rate after the tie-in period

The initial fixed rate is a return permitted by paragraph 11.9(a)(ii). A bank’s standard variable interest rate is an observable interest rate and, in accordance with the definition of a variable interest rate, is a permissible link.  In accordance with paragraph 11.9(a)(ii) the variable rate should be a positive rate.

The variation of the interest rate after the tie-in period is non-contingent and since the new rate (ie the bank’s standard variable rate) meets the condition of paragraph 11.9(a), paragraph 11.9(aB)(i) is met.

Interest on a loan is referenced to 2 times the bank’s standard variable rate

In accordance with the definition of a variable rate, the contractual interest rate payable can be linked to a single observable interest rate. A bank’s standard variable rate is an observable rate and meets the definition of a variable rate, but the rate in this example is 2 times the bank’s standard variable rate and the link to the observable interest rate is leveraged.  Therefore, the rate in this example is not a variable rate as described in paragraph 11.9(a).  The instrument is measured at fair value in accordance with Section 12.

As can be seen from the above conditions, whilst Section 11 concerns basic financial instruments, the conditions that have to be met are not the easiest to comprehend.  Fortunately only in complex cases will these provisions need to be consulted, but this is an area which accountants need to be aware of in the new UK GAAP.

Accounting for basic financial assets and financial liabilities

Financial assets and financial liabilities should initially be measured at transaction price. ‘Transaction price’ should also include transaction costs (ie directly attributable costs relating to the acquisition of a debt instrument).  However, if a financial instrument is measured at fair value through profit or loss, transaction costs are excluded.  This concept can be illustrated using two examples:

Example – investment in a listed company

Company A acquires some equity shares in Company B. Company B is a listed company on a recognised stock exchange.

Company A should measure the investment in Company B at the cost of the investment excluding transaction costs which should be recognised in profit or loss.  After initial recognition, Company A should account for its investment in Company B at fair value through profit or loss.

Example – investment in an unlisted company

Company C acquires some equity in Company D. Company D is a privately owned company and is not listed on a recognised stock exchange.

Company C should measure the investment in Company D at the cost of the investment including the incremental transaction costs.  This is because (unlike in Company B’s situation above), it will not be possible for Company C to obtain a reliable fair value of its investment in Company D at subsequent reporting dates.

Paragraph 11.13 then talks about financing transactions. A financing transaction might occur in relation to a sale of goods or services and it has been agreed that payment be deferred beyond normal business terms or is financed at a rate which is not considered to be a market rate of interest.  When these situations present themselves, the company must measure the financial asset or financial liability at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.

Example – loan to another entity

Fred is the sole director of Company E. He is very good friends with Bill who is the sole director of Company F.  Bill’s company is having a few cash flow problems, so Fred agrees to make a long-term loan to Bill.

This represents a financing transaction and the financial statements of Company E will show a debtor in its financial statements representing the present value, inclusive of interest payments and repayment of capital, of the amount receivable from Company F. 

Example – bank loan

In order to finance their working capital requirements before implementation of their expansion programme, Company G approaches their bank for a loan. The bank agrees to the loan at a market rate of interest and the proceeds are duly credited to Company G’s bank account the day after the loan agreement is signed.

When an entity takes out a bank loan (or indeed any other form of loan), a creditor is recognised in the entity’s balance sheet. Under Section 11 of FRS 102, this will be the present value of the cash payable to the bank (ie including interest payments and repayment of capital).

Example – goods purchased from a supplier

Company H buys goods on normal credit terms from Company I. The terms of credit are 30 days from the date of the invoice.

For goods which are purchased from a supplier on normal (ie short-term) credit terms, a trade creditor is recognised at the undiscounted amount due to the supplier – in other words at the invoice price. FRS 102 does not require any discounting in these respects (this would also apply to normal trade debtors).

After initial recognition debt instruments which meet the conditions in paragraph 11.8(b) of FRS 102 are measured at amortised cost.  The term ‘amortised cost’ is defined in the Glossary to FRS 102 as:

‘The amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectability.’

Included in the definition of ‘amortised cost’ is reference to the ‘effective interest method’. The Glossary defines the ‘effective interest method’ as:

‘A method of calculating the amortised cost of a financial asset or a financial liability (or a group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period.’

When using the effective method the interest income/expense is allocated over the relevant period using the effective interest rate.  The ‘effective interest rate’ is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the carrying value of the asset or liability.

Example – calculating amortised cost using the effective interest method

A company borrows £1m on 1 January 2015 for a 10-year period by issuing loan notes with a coupon rate of 7%.  The provider of the finance charges an arrangement fee of £12,500.  Interest is payable at a rate of 7% and this is payable annually starting at the inception of the loan.  The redemption amount of the loan is at par at the end of year 10.  The company has chosen not to prepay any of the loan amounts and the discount rate which would be necessary so as to be equivalent to 10 annual payments of £70,000 (£1m x 7%) plus the redemption amount at maturity of £1m to the initial carrying value of £987,500 is 7.179%.  The opening value is calculated as:

Principal amount of loan (£1 million) less arrangement fee (£12,500) equals carrying value at start of loan of £987,500.

Using the amortised cost and effective interest method, the loan interest is allocated to profit or loss over the life of the loan and will amount to £712,500 which is the total of the interest coupon plus the fee as follows:

*adjusted for rounding difference

Throughout the life of the loan the total interest payments of £700,000 will be credited through profit or loss and debited to the loan account.  The total finance costs of £712,500 will be debited to profit or loss and credited to the loan liability account.  On redemption the entries will be to credit bank with £1 million and debit the loan liability account.

Conclusion

This article has considered the conditions that have to be met to class a financial instrument as ‘basic’. However, the conditions are quite complex and so this article has examined the principles involved.  In addition because Section 11 requires debt instruments that meet the conditions in paragraph 11.9 to be measured at the end of each reporting period at amortised cost (and hence the use of the effective interest method), this article has examined the principles in the use of such a method.

Category: Accounting and standards, Audit