Section 9 – Financial Instruments

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Section 9 – Overview

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Section 9 – Analysis Part 1

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Section 9 – Analysis Part 2

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Section 9 – Analysis Part 3

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Section 9 – Financial Statements

Summary

Section 9 deals with the recognition, derecognition and measurement criteria of all financial instruments including investments in subsidiaries, associates and joint ventures. It also details the indicators or impairment for financial assets that are classed as financial instruments under Section 9.

The section covers all financial assets and liabilities other than those stated in Section 9.3 below. Examples of financial instruments covered include:

cash;
accounts receivable and payable (trade debtors and creditors);
commercial paper and commercial bills held;
all types of bank accounts;
bonds, loans and similar instruments regardless of the terms;
loans receivable/payable regardless of terms
investments of all kind (in shares, long term loans etc.);
investment in listed shares, collective investment funds
investment in subsidiary, associate or joint ventures (jointly controlled entities)
options, warrants, futures contracts, forward contracts and interest rate swaps
accrued income
preference shares which are classified as a liability under Section 17 of FRS 105.

Section 9 does not apply to the following financial instruments:

Financial instruments that meet the definition of an entity’s own equity and the equity component of compound financial instruments issued by the reporting entity that contain both a liability and an equity component;
Leases, to which Section 15 Leases applies (impairment and derecognition rules in Section 9 do apply however);
Employers’ rights and obligations under employee benefit plans, to which Section 23 Employee Benefits applies;
Contingent consideration for the acquirer (see Section 14)
Reimbursement assets accounted for in accordance with Section 16 Provisions; and
Financial guarantee contracts (see Section 16).

A financial instrument is defined in FRS 105 as a contract that gives rise to a financial asset of one entity and a financial liability of another entity.

What is new when compared to FRSSE/old GAAP (excluding FRS 26 adopters)?

No ability to hold assets as held to maturity instead they must be reviewed for impairment and temporary impairments must be recognised. Old GAAP/FRSSE allowed assets to be carried at held to maturity.

What is new when compared to FRS 102 and FRS 26 adopters?

FRS 105 does not permit financial assets or liabilities to be carried at fair value. Instead they must be carried at cost less impairment or if applicable transaction price less repayments, plus interest etc. plus/minus unmortised transaction costs. FRS 102/FRS 26 required such items to be fair valued through the P&L.

FRS 102 requires financial instruments/debt instruments which include a financing arrangement (i.e. provided at non market rates and not repayable on demand) to be initially measured at the present value of the future cash flows discounted at a market rate of interest and subsequently held at amortised cost with the difference being recognised in the profit and loss on an effective interest rate basis. FRS 105 does not permit this treatment instead such items are carried at:

the transaction price initially (i.e. the amount of the loan received/advanced); and
subsequently at transaction price plus (if asset)/minus (if liability) unamortised transaction costs where material less repayments, plus interest less impairments.

FRS 102 required certain financial assets to be carried at fair value, FRS 105 does not permit this, and hence adjustments will be required on transition to FRS 105.

FRS 105 does not permit any fair valuing, hence listed shares must be stated at cost less impairment. FRS 102/FRS 26 required these to be fair valued.

FRS 102 set out the definition of basic and non-basic instruments with a different accounting treatment for each. FRS 105 does not include this instead all financial instruments are categorised the same as detailed above.

Section 11 of FRS 102 excludes investments in subsidiaries, associates and joint ventures to come within the definition of a financial instrument and instead had separate rules for accounting for such investments. Under FRS 105 investments in subsidiaries, associates and joint ventures come within the same rules as other financial instruments, such investments are required to be carried at cost less impairment, there is no fair value option.

FRS 105 does not permit derivatives to be carried at fair value instead they must be carried at cost initially and written off over the life of the derivative and disclosed.

FRS 105 has significantly less disclosures than old GAAP and FRS 102 and only requires disclosures of the total amount of:

financial commitments;
guarantees; and
the nature and form of any financial asset given as security in respect of its commitments, guarantees, contingencies.

FRS 105 requires sales/purchases made on abnormal credit terms to be recognised initially at the cash value which is subsequently released on a straight line basis over the credit term. This compares to FRS 102 where this should be released over the life of the credit term on an effective interest basis. The treatment under FRS 105 is the same as what was required under FRSSE/old GAAP.

Section 9.16 to 9.19 deals with impairment of financial assets. An impairment loss is recognised in the profit and loss where there is objective evidence of an impairment.

Under old GAAP there are no specific requirements relating to impairment of financial assets where FRS 26 was not adopted (FRS 26 was not applicable for entities that applied the FRSSE). For fixed asset investments (other than investments in subsidiaries, associates and joint ventures i.e. <20% investment), permanent diminution in value had to be recognised in the P&L under old GAAP. Current assets were measured at lower of cost and net realisable value. Section 9 gives more detailed guidance.

What is different?

The disclosure requirements under FRS 105 are significantly reduced compared to FRS 102 and Old GAAP/FRSSE.

Derecognition of financial assets for non FRS 26 adopters was dealt with in FRS 5, where the substance of a transaction was considered. Under Section 9 there is detailed guidance in relation to when an asset is to be derecognised but essentially it should come to the same answer as under old GAAP/FRSSE. FRS 5/FRSSE allowed linked presentation which is not allowed in FRS 102.

Derecognition of financial liabilities were not specifically dealt with in old GAAP/FRSSE instead FRS 5 approached liability derecognition as an issue of derecognition of a related asset. Section 9 provides detailed guidance on when to derecognise a liability and in section 9.25 it states that it should only be derecognised when the obligations specified in the contract are discharged, settled or expired.

Under FRS 102, Section 27 dealt with the impairment of investments in associates, joint ventures and subsidiary shares, however the impairment indicators to be reviewed under FRS 105 for such an investment are stated in Section 9-finanical instruments and as a result some of the impairment indicators differ. This is also applicable for entities transitioning from FRSSE/old GAAP who would have looked to FRS 11. That said the indicators in Section 9 are only indicative and as such the indictors in Section 21 of FRS 105 are likely to also be reviewed so it should not result in a significant difference.

Other standards which impact Section 9 where differences arise:

Section 24 – Income tax – FRS 105 does not permit deferred tax to be recognised. Under FRS 102/FRSSE/old GAAP there was a requirement to recognise deferred tax. Therefore where items were held at fair value under these GAAP’s, particularly FRS 102 it may have been necessary to recognise deferred tax on any uplift or downward movement (if conditions met) on the financial instruments. If this is the case there is likely to be an adjustment on transition to derecognise the related deferred tax.

It is also possible that tax will be payable /refundable on adjustments that fell out for tax purposes on transition depending on the nature of the adjustment.

What are the key points?

Investment in subsidiaries, associates and joint ventures to be carried at cost less impairment;
Financial instruments other than investments in subsidiaries, associates, joint ventures and derivatives to be carried at the transaction price initially and subsequently at transaction price plus (for financial assets)/minus (for financial liabilities) unamortised transaction costs where material less repayments, plus interest less impairments.
Derivatives to be carried at transaction price less impairment and released to the profit and loss over the term of the contract on a straight line basis.
Transaction costs (i.e. arrangement fees, commitment fees and any other directly attributable costs) should be capitalised and set against the related financial liability /asset where material and released to the profit and loss account over the life of the instrument itself.
Not permitted to fair value any financial instruments;
No requirement to recognise debt instruments initially (e.g. loans at non-market rates not repayable on demand) at the present value of the future cash flows instead these are to be recognised at transaction price (i.e. the amount of the loan actually received/advanced).
Sales/purchases made on abnormal credit terms to be recognised initially at the cash value which is subsequently released on a straight line basis over the credit term;
Premium/discounts on bonds to be released to the profit and loss account at a constant rate on the financial assets/liabilities carrying amount (excluding transaction costs). The constant rate rule applies to all instruments other than where it relates to sale/purchases at abnormal credit terms.
Financial assets are derecognised only when the rights to the cash flows from the asset have expired or are settled; or the entity has transferred all the risks and rewards of ownership, or where ownership is transferred but control is relinquished.
Impairment to be booked where impairment indicators exist even if temporary in nature – cannot use held to maturity argument. Impairment indicators detailed in Sections 9.16-9.18
Disclosure required of value of financial commitments, guarantees and contingencies not recognised as well as details of the nature and form of financial assets given as security.
Impairment can be reversed if indicators of the original impairment reserves.

What do accountants need to do?

Get to grips with this new standard.

Review your client portfolio and assess the existence of debt instruments and advise clients of the impact this policy will have on the profit line (e.g. i.e. no longer a requirement to present value non market rate loans which are not repayable on demand and hence no interest income/expense to be recognised in the P&L for the unwinding of this discount – applicable to entities that previously applied FRS 102).

Advise clients of the inability to carry financial assets/liabilities at fair value.

Advise client of the reduced administrative and accounting burden as a result of the simplified rules under FRS 105 when compared to FRS 102.

Advise clients who are considering paying dividends during periods ended on or after 1 January 2016 (assuming the entity adopts FRS 105 in the year ended 31 December 2016), that the directors need to ensure that the company has sufficient distributable reserves under FRS 105 (once the transition adjustments have been recognised) to allow for such a dividend.

Advise clients on the need for tax adjustments on transition to be included in the 2016 tax computation and beyond where items have fallen out for tax purposes as a result of the opening balance sheet being restated to show the restated FRS 105 balance (only applicable where it would be taxable/tax deductible under tax law). This adjustment will be taxable/tax deductible over a 5 year period.

Advise clients of the best choice for their company based on the exclusions included in FRS 105.

What do companies need to do?

Understand the differences between old GAAP/FRSSE/ FRS 102 and section 9 of FRS 105.

Quantify the effect on distributable profits as a result of the transition adjustments required to adopt this standard as it is likely that there will be adjustments which will impact distributable reserves.

Where a dividend is due to be paid for periods ended after 1 January 2016, then the companies need to ensure they have sufficient distributable reserves under FRS 105 to allow for such a dividend (after considering the adjustments posted at and since the date of transition).

Consider whether covenants on loans will be affected as a result of the new requirements.

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