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Section 11: Basic Financial Instruments.
11.2 Accounting policy choice.
11.2.1 Extract from FRS 102 Section 11.2-11.2A.
11.2.2 OmniPro comment – Accounting Policy Choice.
11.3 Scope of the Section 11 and Section 12.
11.3.1 Extract from FRS 102 Section 11.3, 11.5, 11.7 and Glossary to FRS 102.
11.3.2 OmniPro comment – Scope of Section 11.
11.3.2.1 Financial assets and liabilities not within the remit of Section 11 and 12.
11.4 Classification of financial instruments.
11.4.1 Extract from FRS 102 Section 11.6 and 11.8.
11.4.2 OmniPro comment – classification of financial instruments and scope (within Section 11 or 12)
11.4.2.2 – Investment in Shares.
11.5 Conditions for debt instruments to meet the definition of a basic financial instrument
11.5.1 Extract from FRS 102 Section 11.9.
11.5.2 OmniPro comment – basic financial instruments.
11.6 Initial and subsequent measurement of debt instruments.
11.6.1 Extract from FRS 102 Section 11.12-11.20.
11.6.1.2 Subsequent measurement
11.6.1.3 Amortised cost and effective interest method.
11.6.2.2 Short-term receivables/payable within one year
11.6.2.3 Transaction costs – definition/treatment
11.6.2.4 Effective interest rate calculation and amortised cost
11.6.2.4.1 Effective interest rate
11.6.2.4.3 Put or call options when calculating effective interest rate
11.6.2.4.4 Diagram 1 Rules for Accounting for basic financial instruments
11.6.2.4.5 – Financing Arrangement
11.6.2.4.6 Steps in determining the effective interest rate
11.6.2.4.7 Changes in cash flow estimates (amortised cost model)
11.6.2.4.8 Non market loans- inter-company loan / director’s loans
11.6.2.4.8.1 Determining the market rate of interest
11.6.2.4.8.2: Analysis of debt and credits on initial recognition of loans – financing arrangements.
11.6.2.4.9 Sales and purchases made under unusual credit terms – Debtors/creditors
11.6.2.4.11 Loans repayable on demand
11.6.2.4.12 Loan repayable on demand but with notice of 1 year and 1 day
11.6.2.4.15 Variable interest rate over the life of the loan
11.6.2.4.16 Issues surrounding directors or intra-group loans
11.6.2.4.16.1 Factors that indicate a related party loan is not at market rates.
11.7.1 Extract from FRS 102 Section 11.27-11.32.
11.7.2.1.2 Fair value hierarchy
11.8 Impairments of financial assets held at cost or amortised cost
11.8.1 Extract from FRS 102 Section 11.21-11.26.
11.8.2.1 Indicators of Impairment
11.8.2.2 Individual and group impairments.
11.8.2.3 Impairment debt instruments.
11.8.2.4 Reversal of Impairments.
11.8.2.5 Impairment of financial assets carried at cost
11.9 Derecognition of a Financial Asset
11.9.1 Extract from FRS 102 Section 11.33-11.35.
11.9.2 OmniPro comment – Decrecognition of Financial Assets.
11.10 Derecognition of financial liabilities.
11.10.1 Extract from FRS 102 Section 11.36-11.38.
11.6.2.4.5 Derecognition rules – overview
11.10.2.2 Derecognition of Financial Liability.
11.11.1 Extract from FRS 102 Section 11.38A.
11.11.2 OmniPro comment – Presentation – set off
11.12.1 Extract from FRS 102 Section 11.39-11.48A.
11.12.2.1 Disclosure requirements.
11.12.2.2 Sample Disclosure requirements.
11.12.2.2.1 Extract from accounting policy notes
11.12.2.2.2 Extract of notes to the financial statements – Financial instruments note disclosures
11.12.2.2.3 Extract of notes to the financial statements – interest disclosures.
11.12.2.2.3.1 Note: Interest receivable and similar income.
11.12.2.2.3.2 Note: Interest payable and similar expenses.
11.12.2.2.4 – Debtors Disclosures
11.12.2.2.5 – Creditors disclosures
11.12.2.2.7 Statement of Comprehensive Income
11.12.2.2.8 – Statement of Change in Equity
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11.10 Derecognition of Financial Liabilities
11.10.1 Extract from FRS 102 Section 11.36-11.38
11.36 An entity shall derecognise a financial liability (or a part of a financial liability) only when it is extinguished i.e. when the obligation specified in the contract is discharged, is cancelled or expires.
11.37 If an existing borrower and lender exchange financial instruments with substantially different terms, the entities shall account for the transaction as an extinguishment of the original financial liability and the recognition of a new financial liability. Similarly, an entity shall account for a substantial modification of the terms of an existing financial liability or a part of it (whether or not attributable to the financial difficulty of the debtor) as an extinguishment of the original financial liability and the recognition of a new financial liability.
11.38 The entity shall recognise in profit or loss any difference between the carrying amount of the financial liability (or part of a financial liability) extinguished or transferred to another party and the consideration paid, including any non-cash assets transferred or liabilities assumed.
11.10.2 OmniPro comment
11.10.2.1 Derecognition Rules – Overview
See diagram below for the rules with regard to derecognition of financial assets and liabilities as stated in Section 11.33 and 11.36 of FRS 102
IMAGE TO BE INSERTED
11.9.2.2 Derecognition of Financial Liability
In its simplest terms, a liability is extinguished once a loan is repaid in full or the entity has been released from the obligation by the creditor.
However there are instances where it is not as simple to determine whether a liability is extinguished or if in fact it has just been modified. The standard merely states that a substantial modification should be treated as an extinguishment (Section 11.37 FRS 102) . It does not provide detail on how to account for a modification which is not considered substantial i.e. how to account for the difference between the present value of the modified cash flows discounted at the original effective interest rate and the carrying amount of the debt instrument at that date. There is a choice as to how this difference should be accounted for.:
- Recognise the difference in the profit and loss account to accelerate the charge/income (as shown in example 13a at 6.2.4.7) It is important to realise if it is just a change in cash flow then this treatment must be used; or
- Charge the interest over a new effective interest rate such that the carrying value at the end of the term equates to the actual capital amount. Where fees are incurred these would be netted against the present value of the future cash flows and amortised over the remaining life of the debt instrument.
Neither does it define what the meaning of a substantial modification is. Some qualitative examples which can help in an assessment as to whether there is a substantial modification are:
- A change in interest rate from fixed to floating, or vice versa
- Material difference between the maturity date before the modification and after the modification.
- Material changes in covenants and conversion terms between the old and new debt.
The above are only qualitative factors. IAS 39 of IFRS provides a quantitative guideline as to what should be considered to be a substantial modification. IFRS outlines that a substantial change arises where the discounted present value of the cash flows under the new terms, including any fees paid, net of any fees received discounted using the original effective interest rate is at least 10% different from the discounted present value of the remaining cash flows of the original financial liability. Although this is not specifically stated in Section 11, it appears reasonable that such a basis be used as a difference of 10% would be substantial. See example below
Example 25: Substantial modification of a loan
Company A took out a loan for CU1,000,000 on 01/01/15 with a bank which was due to be repaid on 31/12/18. Interest was charged at a rate of 7% (CU70,000 per annum) and arrangement fees of CU5,000. Due to poor trading conditions at 31/12/16, the company renegotiated the facility with the bank. The revised terms are as follows:
- loan is now repayable on 31/12/22
- Interest – 6.25% (6.25%*CU800,000= CU50,000)
- Maturity – 31/12/23
- Final principal due on maturity of CU800,000
- Cost of renegotiation of CU4,000
Should the above be treated as a modification of an existing loan (i.e. not a substantial modification) or an extinguishment of an existing loan and its replacement by a new loan?
Step 1: Amortise old facility up to date of the modification. The effective interest rate has been determined through the use of Excel.
Step 2: Calculate present value of future estimated cash flows under revised terms discounted at original EIR of 7.148%
Determine if a substantial modification has occurred i.e. is the modification 10% or more
Extent of modification = A – B = (CU997,325-CU765,482) = 23.2% A CU997,325
Where A = The present value of remaining cash flows under original terms using original EIR = CU997,325
Where B = The present value of revised cash flows using original EIR of CU765,482
As the difference of CU231,843 (CU997,325-CU765,482) is greater than 10%, this is treated as an extinguishment. Therefore, the journal required to derecognise are:
| CU | CU | |
| Dr Financial Liability | 997,325 | |
| Dr Interest Expense | 2,675 | |
| Cr Cash | 1,000,000 |
In effect what gets written off to the P&L is the unamortised element of the initial arrangement fee of CU5,000.
The fair value of the new financial liability would then be recognised, the fair value could be obtained by discounting the cash flows of the modified loan at the interest rate at which the company could have obtained this new loan at in the market on that date. If we assume the fair value of the new loan is CU999,000, the accounting journals would be:
| CU | CU | |
| Dr Cash | 1,000,000 | |
| Cr Financial Liability | 999,000 | |
| Cr Interest Expense | 1,000 |
If the above was not above 10% and therefore was not deemed to be a substantial modification, there is a choice as to how to account for the unamortised expenses. The unamortised expenses can be amortised over the remaining life of the negotiated instrument net of any associated fees (can be on a straight line basis or a revised EIR basis so as to allow the unamortised element to come to the capital value at the end of its life e.g. in the example above the CU993,325 (CU997,325-CU4,000 fees) would be amortised such that the capital amount comes to CU800,000 by the end of 2023) or as would be done for a change in estimated cash flows, the current carrying amount is adjusted to reflect the revised present value of estimated cash flows and the remaining amount amortised over the original effective rate of interest (See example 13a at 11.6.2.4.7 for example of same).
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Examples
Example 1: Investment in shares.
Example 2: Investment in shares – 15%.
Example 3: variable and fixed interest payments.
Example 5: Fixed and variable interest payments.
Example 6: Fixed rate loan for a set period and then a reversion to the banks variable rate.
Example 8: Loan/bond which is convertible into the borrower’s equity.
Example 9: Loan issued which is linked to a general inflation index.
Example 10: Variation in return.
Example 11: Prepayment options.
Example 12: Loan extension option.
Example 12a: Unguaranteed Capital
Example 12b: Collective investment funds.
Example 13: loan at market rates with transaction costs.
Example 13a: Change in estimate.
Example 14: Intercompany loan from a parent company.
Example 15: Loan provided to the company by a director
Example 16a: Intercompany loan from a related party or a fellow subsidiary.
Example 16b: Loan from subsidiary to the parent company.
Example 16c: Sale with unusual credit terms.
Example 16d: Purchase with unusual credit terms.
Example 17a: Loans repayable on demand..
Example 17b: Loan repayable on demand but with notice of 1 year and 1 day.
Example 18: Bonds – discount/premium.
Example 20: Impairment of debt instruments.
Example 20a: Bonds with an impairment
Example 21: Asset recognised due to settlement
Example 22: Sale of debtors with recourse.
Example 23: Sale of debtors without recourse.
Example 24: Transfer of assets at fair value subject to a call option.
Example 25: Substantial modification of a loan.
Example 26: Sample disclosure requirements
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