FRS102 & Financial Instruments – A New Set of Challenges

With the final year of old UK GAAP reporting nearly done and dusted, many of our clients are now starting to focus in earnest on restating their opening balance sheet and the 2014/15 financial year under FRS102. We have been supporting a number of RPs with the various financial instruments complexities that FRS102 presents, and have found this to be like opening a can of worms when one gets down into the numerical and technical detail!

A recent engagement for a client which has already been forced to fully restate its 2014/15 financial year under FRS102 (and have the numbers audited) in relation to a financing transaction necessitated it going into the lowest level of detail and fully working through all of its financial instruments from end to end. This has clarified our perspective on what the key FRS102 financial instruments challenges are and we have set these issues out at a high level below. All entities transitioning from old UK GAAP to FRS102 which have any debt or derivative instruments will be forced to address these challenges at some level (albeit that not all of them will apply in all cases).

As is usually the case with complex accounting issues, we think the best approach is to formulate a clear view on what the accounting treatment in each area should be (which necessitates fully working through the numbers), and then to present a robust (and defendable) argument to your auditor. In this case, we would advise pulling together a comprehensive financial instruments paper (which documents both the numbers and the rationale supporting the proposed accounting approach) which can simply be handed over to your auditor, after which point, the onus is on them to respond with any challenges:

  • FRS102 opening balance sheet: as regards treasury portfolios, we are seeing two approaches emerging to addressing the FRS102 opening balance sheet: either (i) go back to the inception of all of your debt instruments and recalculate the FRS102 accounting entries retrospectively, or (ii) demonstrate robustly to your auditor that going through this process would not result in a materially different result versus simply equating your FRS102 opening balance sheet debt position to the UK GAAP closing position to the opening FRS102 position less unamortised fees. As the amount of workload implied by (i) is potentially huge and may be simply impractical (e.g. due to incomplete records), we would advise attempting (ii) in the first instance, although formulating the arguments and numbers to support this approach may not be straightforward
  • Effective Interest Rate (“EIR”) and amortised cost for loan instruments: this is a paradigm shift in debt instrument accounting and is required going forwards under FRS102, on the face of it meaning that all reporting entities will need to perform such a calculation for all of their individual loans/bonds if they are to comply with FRS102. Complexities to address include constructing the EIR/Amortised Cost model itself (and persuading auditors to sign this off!), as well as dealing with factors impacting the EIR calculation, such as margin steps, fixed rate steps, premiums/discounts (requiring amortisation on an EIR basis) and how EIR is calculated for floating/index-linked debt instruments. In this area there are a number of potential debates about materiality but it’s difficult to get into these without running at least some of the numbers.
  • Derivatives fair values: any standalone derivative needs to go on balance sheet at fair value under FRS102. This is straightforward in principle providing a reporting entity has access to MTM values for its swap portfolio, although there may be a debate to be had with auditors around whether the data source is appropriate and whether the MTM values correspond to “fair value” as defined in FRS102
  • Hedge Accounting: any entity which has standalone derivatives and wishes to mitigate the associated Income statement volatility will need to put in place a hedge accounting framework (with associated policies, documentation and financial models). This is complex area, particularly as regards the structuring and calculations since most RPs which have derivatives will find the need to construct an optimised “hypothetical derivatives” portfolio in order to support hedge accounting, with numerous rules and conventions governing how these calculations should be performed. A technology solution which performs these calculations is recommended.
  • Historical loan restructurings: Although clients may be able to avoid dealing with accounting complexities arising from loans which were restructured prior to FRS102 transition, any entities which have transacted loan restructures since 31 March 2014 will now need to demonstrate to their auditor that an “extinguishment” of the previous liability (and re-recognition at fair value, which would impact balance sheet value, income statement, and EIR going forward) is not required. The approach to this is the same as under IAS 39 and IFRS 9 and requires the entity to perform a quantitative assessment of the change in the value of the liability (discounted at the original EIR) in order to evidence that it has not moved by more than 10%. Going forward, any FRS102 entity contemplating a debt restructure will need to be mindful of the impact of this change.
  • CVA/DVA Adjustments: A number of RPs which have standalone derivatives and have elected to apply IFRS9 (rather than apply chapters 11 and 12 of FRS102) are finding that this leads to the requirement to make credit and debit valuation adjustments to their swap portfolio. These adjustments are required to reflect the impact of counterparty credit risk and own credit risk in the swap valuations, since conventional MTMs are derived using rates which are considered close to “risk-free”. The adjustments are often material in size and are highly complex to calculate, requiring sophisticated financial modelling tools

Prepared by Phil Jenkins, Managing Partner and George Karalis, Director
11th September 2015

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