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Section 11: Basic Financial Instruments
Section 11 defines basic financial instruments for all companies with the exception of public benefit entities. Section 12 applies to other, more complex financial instruments and transactions. If an entity enters into only basic financial instrument transactions then Section 12 is not applicable. However, even entities with only basic financial instruments shall consider the scope of Section 12 to ensure they are exempt. Basic financial instruments coming within the scope of section 11 are:
- Cash;
- Demand and fixed term deposits;
- Commercial paper and bills;
- Notes, loan receivable and payable;
- Bonds and similar debt instruments
- Accounts payable, accounts receivable;
- Investments in non-convertible preference shares, non-puttable ordinary and preference shares; and
- Commitments to make or receive a loan to another entity that cannot be settled net in cash;
- Loans due to or from group companies, director’s loan accounts.
Accounting policy choice
Extract from FRS 102 Section 11.2-11.2A
11.2 An entity shall choose to apply either:
(a) the provisions of both Section 11 and Section 12 in full; or
(b) the recognition and measurement provisions of IAS 39 Financial Instruments: Recognition and Measurement (as adopted for use in the EU), the disclosure requirements of Sections 11 and 12 and the presentation requirements of paragraphs 11.38A or 12.25B; or
(c) the recognition and measurement provisions of IFRS 9 Financial Instruments and/or IAS 39 (as amended following the publication of IFRS 9) subject to the restriction in paragraph 11.2A, the disclosure requirements of Sections 11 and12 and the presentation requirements of paragraphs 11.38A or 12.25B; to account for all of its financial instruments. Where an entity chooses (b) or (c) it applies the scope of the relevant standard to its financial instruments. An entity’s choice of (a), (b) or (c) is an accounting policy choice. Paragraphs 10.8 to 10.14 contain requirements for determining when a change in accounting policy is appropriate, how such a change should be accounted for and what information should be disclosed about the change.
11.2A An entity, including an entity that is not a company, that has made the accounting policy choice in paragraph 11.2(c) to apply the recognition and measurement provisions of IFRS 9 shall depart from the provisions of IFRS 9 as follows:
A financial asset that is not permitted by the Small Companies Regulations, the Regulations, the Small LLP Regulations or the LLP Regulations to be measured at fair value through profit or loss shall be measured at amortised cost in accordance with paragraphs 5.4.1 to 5.4.4 of IFRS 9.
OmniPro comment
Entities should decide which policy to adopt and then apply this consistently. They cannot pick and choose for different financial assets and liabilities. If an entity were to change the policy in the future, it would be a change of accounting policy which would require a prior year restatement under Section 10 – Accounting Policies.
Section 11 and Section 12 are simpler than the alternative and require significantly less disclosure. IFRS 9 brings embedded derivatives into scope and lay down differing hedge accounting methods. Further information on IFRS 9 is not within the scope of this article.
Scope of the Section 11 and Section 12
Extract from FRS 102 Section 11.5, 11.7 and Glossary to FRS 102
Section 11 applies to all financial instruments meeting the conditions of paragraph 11.8 except for the following as detailed in section 11.7 which also meet the conditions but are dealt with under separate standards:
(a) Investments in subsidiaries, associates and joint ventures;
(b) 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.
(c) Leases, to which Section 20 Leases applies. However, the derecognition and impairment rules in Section 11 applies
(d) Employers’ rights and obligations under employee benefit plans, to which Section 28 Employee Benefits applies;
(e) Financial instruments, contracts and obligations to which Section 26 Share-based payment applies, and contracts within the scope of paragraph 12.5
(f) Insurance contracts (including reinsurance contracts) that the entity issues and reinsurance contracts that the entity holds (see FRS 103 Insurance Contracts).
(g) Financial instruments issued by an entity with a discretionary participation feature (see FRS 103 Insurance Contracts).
(h) Reimbursement assets accounted for in accordance with Section 21 Provisions and Contingencies.
(i) Financial guarantee contracts (see Section 21).
11.3 A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Glossary to FRS 102 – A financial asset is any asset that is:
- Cash
- An equity instrument of another equity
- A contractual right:
- To receive cash or another financial asset from another entity; or
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity
- A contract that will or may be settled in the entity’s own equity instruments and:
- Under which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
- That will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, the entity’s own equity instruments do not include instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
A financial liability is any liability that is:
- A contractual liability to deliver cash or another financial asset from another entity; or
- To exchange financial assets or liabilities with another entity under conditions that are potentially unfavourable to the entity;
- A contract that will or may be settled in the entities own equity instruments and:
- Under which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
- That will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose, the entity’s own equity instruments do not include instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
11.5 Basic financial instruments within the scope of Section 11 are those that satisfy the conditions in paragraph 11.8. Examples of financial instruments that normally satisfy those conditions include:
(a) cash
(b) demand and fixed-term deposits when the entity is the depositor, eg bank accounts;
(c) commercial paper and commercial bills held;
(d) accounts, notes and loans receivable and payable;
(e) bonds and similar debt instruments;
(f) investments in non-convertible preference shares and non-puttable ordinary and preference shares; and
(g) commitments to receive a loan and commitments to make a loan to another entity that meet the conditions of paragraph 11.8(c).
OmniPro comment
The definition of financial assets and liabilities does not differentiate between those that are basic and therefore coming within Section 11 and those that are other than basic, neither does it deal with what types come within the remit of Section 11 and Section 12. Section 11.8 and 11.5 as detailed above provide detailed guidance on what is determined to be a basic financial instrument. This is discussed further below. Section 11 and section 12 therefore, applies to investments in equity which is less than 20% of the share capital of the investee as anything above these amounts will be accounted for under other sections within FRS 102 (assuming investments under 20% do not provide the entity with a significant influence or control and therefore within the scope of Section 14-Associates, Section 15-Joint Ventures or Section 9-Consolidated and Separate financial statements).
Example 1: Investment in shares
Company A, hold an investment of 25% in the ordinary share capital of Company Y which gives Company A significant influence. In this particular case, this investment does not come within the remit of Section 11 for Company A as this is considered an associate which is accounted for in accordance with Section 14-Investments in Associates.
Example 2: Investment in shares – 15%
Company A hold an investment of 15% in the ordinary share capital of Company Y (which does not provide Company A with significant influence). This comes within the definition of a financial instrument and is accounted for in accordance with Section 11 as there is no puttable element attaching to the rights of the shares.
It is evident from above that foreign currency forward contract interest rate swaps and hedging do not come within the definition of basic and are therefore accounted for under Section 12.
The principal assets and liabilities on the balance sheet which are not classed as a financial instrument are:
- PPE and investment property;
- Inventories;
- Construction contract work in progress;
- Prepayments for good or services;
- Deferred income and warranty obligations where settled by delivery of goods or services;
- Accrued dividend where the entity does not have to deliver cash; and
- Current and deferred tax.
The other items scoped out in section 11.7 (as detailed above) are financial instruments however they do not come within the Section 11 and Section 12 as they are dealt with by other standards. Contingent consideration which is not detailed in 11.7 is also a financial instrument however it is scoped out of Section 11 and 12 as it is accounted for in accordance with Section 19 – Business Combinations and Goodwill.
Classification of financial instruments
Extract from FRS 102 Section 11.6 and 11.8
11.8 An entity shall account for the following financial instruments as basic financial instruments in accordance with Section 11:
(a) cash;
(b) 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);
(c) commitments to receive or make a loan to another entity that:
(i) cannot be settled net in cash; and
(ii) when the commitment is executed, are expected to meet the conditions in paragraph 11.9; and
(d) an investment in non-convertible preference shares and non-puttable ordinary shares or preference shares.
11.6 Examples of financial instruments that do not normally satisfy the conditions in paragraph 11.8, and are therefore within the scope of Section 12, include:
(a) asset-backed securities, such as collateralised mortgage obligations, repurchase agreements and securitised packages of receivables;
(b) options, rights, warrants, futures contracts, forward contracts and interest rate swaps that can be settled in cash or by exchanging another financial instrument;
(c) financial instruments that qualify and are designated as hedging instruments in accordance with the requirements in Section 12; and
(d) commitments to make a loan to another entity and commitments to receive a loan, if the commitment can be settled net in cash.
OmniPro comment
A debt instrument can be a financial asset or liability. Examples of debt instruments are:
- Accounts receivable (comes within the scope of Section 11)
- Accounts payable (comes within the scope of Section 11)
- Loan notes receivable or payable (can come within the scope of Section 11 or Section 12 depending on the terms)
- Fixed term and on demand deposits with a bank (comes within the scope of Section 11)
- Intercompany loans payable or receivable (comes within the scope of Section 11 unless there is an option for a balance to be converted into equity from the outset)
- Directors loans (comes within the scope of Section 11 unless there is an option for a balance to be converted into equity from the outset)
- Bonds (can come within the scope of Section 11 or Section 12 depending on the terms)
- Bank loans (can come within the scope of Section 11 or Section 12 depending on the terms)
- Preferences shares which are convertible or redeemable at the option of the holder (comes within the remit of Section 12).
- Compound financial instruments (comes within the remit of Section 12 and the deemed equity element is accounted for under Section 22 – Liabilities and Equity).
- In order to determine whether any of the above meet the definition of a basic financial instrument, they must meet the criteria laid out in Section 11.9 as detailed below.
An investment in shares which is less than 20% (i.e. where significant influence is not achieved) which has no puttable or convertible rights attaching to the shares should be accounted for under Section 11. For example, an investment of 10% shares which can be converted to ordinary shares at the option of the holder would not come within the definition of basic and therefore would be accounted for in accordance with Section 12.
An entity has an investment in non-puttable shares if:
- The entity does not have an option to sell the shares back to the issuer of the shares for cash or another financial asset; and
- There is no arrangement that could result in the shares being automatically redeemed or repurchased by the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder (Section 22.4(a)).
Conditions for debt instruments to meet the definition of a basic financial instrument
Extract from FRS 102 Section 11.9
11.9 The conditions a debt instrument shall satisfy in accordance with paragraph 11.8(b) are:
(a) The contractual return to the holder (the lender), assessed in the currency in which the debt instrument is denominated, is:
(i) a fixed amount;
(ii) a positive fixed rate or a positive variable rate; or
(iv) a combination of a positive or a negative fixed rate and a positive variable rate (eg LIBOR plus 200 basis points or LIBOR less 50 basis points, but not 500 basis points less LIBOR).
(aA) The contract may provide for repayments of the principal or the return to the holder (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.
(aB) The contract may provide for a determinable variation of the return to the holder during the life of the instrument, provided that:
(i) the new rate satisfies condition (a) and the variation is not contingent on future events other than:
– a change of a contractual variable rate;
– to protect the holder against credit deterioration of the issuer;
– changes in levies applied by a central bank or arising from changes in
– relevant taxation or law; or
(ii) the new rate is a market rate of interest and satisfies condition (a). Contractual terms that give the lender the unilateral option to change the terms of the contract are not determinable for this purpose.
(b) There is no contractual provision that could, by its terms, result in the holder losing the principal amount or any interest attributable to the current period or prior periods. The fact that a debt instrument is subordinated to other debt instruments is not an example of such a contractual provision.
(c) Contractual provisions that permit the issuer (the borrower) to prepay a debt instrument or permit the holder (the lender) to put it back to the issuer before maturity are not contingent on future events other than to protect:
(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or
(ii) the holder or issuer against changes in levies applied by a central bank or arising from changes in relevant taxation or law. The inclusion of contractual terms that, as a result of the early termination, require the issuer to compensate the holder for the early termination does not, in itself, constitute a breach of this condition.
(d) Contractual provisions may permit the extension of the term of the debt instrument, provided that the return to the holder and any other contractual provisions applicable during the extended term satisfy the conditions of paragraphs (a) to (c).
OmniPro comment
In relation to Section 11.9 (a), the assessment needs to be completed in the currency of the financial asset or liability it was given or received. There is no requirement that interest is charged on the loan, however where it is charged it can only be a normal interest rate based on the value of the loan which is observable and interest may be a combination of a positive or a negative fixed rate and a positive variable rate.
Example 3: variable and fixed interest payments
A loan contract was issued which stated that the interest rate on the principal is calculated at 12 months LIBOR minus 3%.
In this particular case, this loan consists of a positive variable return (that being 12 month LIBOR) and a negative fixed return (i.e. 3%). Therefore, this meets condition (a) above.
Example 4: a zero coupon
Where no interest is charged and the amount returned is the amount that was loaned, then as the fixed amount is returned it meets the condition in Section 11.9 (a) (i).
Example 5: fixed and variable interest payments
A loan contract was issued which stated that the interest rate on the principal is calculated at 12 months LIBOR plus 3%.
In this particular case, this loan consists of a variable return (that being 12 month LIBOR) plus a fixed return (i.e. 3%). Therefore, this meets condition (a) above.
Example 6: fixed rate loan for a set period and then a reversion to the banks variable rate
For such a loan, as it meets the condition in 11.9 (a) (ii) and given that the variable rate is an observable interest rate, it is a permissible link. Also as the interest rate is a positive rate this meets the definition of a basic instrument.
Example 7: fixed and variable interest payments where there a fixed positive return and a negative variable return
A loan contract was issued which stated that the interest rate on the principal is calculated at 10% less 12 months LIBOR.
For such a loan, the condition in 11.9(a)(i) is satisfied however, condition 11.9(a)(iv) is not as it is a negative variable rate.
Example 8: Loan/bond which is convertible into the borrower’s equity
For such a loan as there is an option to convert to equity it does not meet the definition of a basic instrument.
Example 9: loan issued which is linked to a general inflation index
Such a loan is a basic financial instrument. However, if it is linked to an inflation index which is not general and instead is specific to market, it does not meet the definition of a basic instrument.
Example 10: Variation in return
A loan stating that interest is payable at fixed rate of 2% for the first 2 years and 4% for the remaining 3 years.
Such a loan is a basic instrument as it meets the requirement in 11.9 (aB) i.e. the variation is not contingent on future events as it is explicitly stated from the start.
If in the above example the interest was fixed for the 5 years and then reverts to variable LIBOR rate, this is also determined to be basic financial instrument as it is in the contract, is determinable and not dependent on future contingencies.
Example 11: prepayment options
A loan is issued which states that if repayment is made early, then penalties will be payable to the issuer to compensate them for a fall in interest rates since inception.
Such a clause would meet the basic financial instrument definition as the clause was included to protect the issuer for early termination which is allowed as per Section 11.9(c).
Example 12: Loan extension option
A loan is issued for 10 years at a rate of 3% which provides an option to the borrower to extend the loan for a further 3 years and at that point pay interest at a rate of LIBOR plus 1% at that time.
Given that the variation in return is contingent on the borrower extending the loan and given that the market rate of the loan cannot be known at that time, this does not meet the condition in 11.9(aB). In order for this condition to be met the loan agreement would have to specify that the interest rate charged on the loan after 10 years would be determined at that time. As a result, the loan is classed as complex and within the remit of Section 12. In this case under Section 12, the fair value of the optional exemption would have to be determined based on the facts at each reporting period and the movement posted to the profit and loss account.
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