Professional Documents
Culture Documents
M2. Performance Reporting
M2. Performance Reporting
performance of entities
Contents
Reporting the financial performance of entities .............................................................. 2
CHANGES IN ACCOUNTING POLICIES AND MATERIAL ERRORS (IAS 8): ............................. 2
OPERATING SEGMENTS (IFRS 8): ........................................................................................ 2
FIRST-TIME ADOPTION (IFRS 1): ......................................................................................... 3
INTERIM REPORTING (IAS 34):............................................................................................ 4
RATIO ANALYSIS:................................................................................................................. 4
LIMITATIONS OF FINANCIAL STATEMENTS: ....................................................................... 4
Corporate Reporting .............................................................................................................. 6
Performance Reporting – Sample Question .......................................................................... 6
SAMPLE QUESTION ............................................................................................................. 6
THE 5 STEP MODEL FRAMEWORK ...................................................................................... 7
TREATMENT OF COSTS TO SECURE THE CONTRACT .......................................................... 8
THE FINANCIAL STATEMENTS ............................................................................................. 8
DISCLOSURES .................................................................................................................... 11
Non-current assets ............................................................................................................... 12
INTANGIBLE ASSETS SAMPLE QUESTION ......................................................................... 12
TANGIBLE ASSETS QUESTION ........................................................................................... 15
Reporting the financial performance of entities.................................................................. 20
Financial Instruments ....................................................................................................... 20
IAS 32 THAT LOOKS AT PRESENTATION............................................................................ 20
IFRS 9 DEALS WITH MEASUREMENT ................................................................................ 22
1
Reporting the financial performance
of entities
Performance Reporting
2) The new policy gives a truer and fairer view of the situation.
A change in accounting policy must be applied retrospectively, i.e. restating the current
year and both opening and closing balances of comparative year.
A change in accounting estimate must be applied prospectively, i.e. applying the new
accounting policy from the current year.
1) Recognition;
2) Presentation; Any of these elements can indicate change in accounting policy
3) Measurement.
Note: Another reason that can cause a company to change the comparative information is a
material error in last year’s financial statements.
Under IFRS 8 the entity reports its segments in the same way that it does for internal
management accounting, which gives the user a better understanding of the risk to which
the entity is exposed.
The standard allows the company to report externally on the same basis as for internal
purposes, i.e. there is no necessity to restate information on an IFS basis.
The significance of the segment could be based on revenue, results, or assets using 10%
rule (any one of the three criteria is enough for a segment to be reportable).
2
Remember: The external revenue of the segments identified must exceed 75% of the
external revenue of the business. If not, the entity must identify further operating segments
that were below the 10% rule until more than 75% of the external revenue has been
separately reported.
Revenue; Assets;
- Amortization and other non-cash items; - External revenue by each product or service;
- Share of profit under equity accounted
investments; - Geographical information;
- profit or loss as reported to the chief - Information about major customers (more than
operating decision maker; 10% of external revenue)
Note: There is a practical limit of 10 segments, however, any segment may be reported
separately if this would give a better understanding of the entity.
Transition date is the first day of comparative year, i.e. year before the first full year of
adoption. At this date, the entity must provide a reconciliation under old GAAP to IFRS of
both opening and closing balances of a comparative year. A reconciliation must also be
provided for the comparative year profit.
IFRS 1 allows certain exemptions from full application of IFRS at the transition date:
It allows the entity to use fair value at the transition date as deemed cost where
original cost information is not held by the entity;
It does not require the restatement of business combinations that occurred prior to
the transition date.
Note: Other exemptions relate to borrowing costs, foreign exchange gains and losses,
adoption of IFRS by subsidiaries, associates and joint ventures.
3
INTERIM REPORTING (IAS 34):
RATIO ANALYSIS:
Ratios are not governed by any reporting standard and key things to remember are:
1) A comparison between two entities may not be a direct comparison due to significant
judgement applied;
2) What appears bad for the business in the short term may be indicative of investment
for the long-term success;
3) The success of any strategy is dependent not just on the financial success but also the
non-financial success.
Key advantage: This report can provide the information that cannot be provided by the
financial statements alone.
4
Key disadvantage: It is not precise and can be used to make things sound better than they
actually are.
SMART objectives;
Internal and external comparative information;
Information about objectives that have not been met;
Actions that are being taken to address the shortfalls in the achievement of
objectives.
Note: If nothing is done in respect of CSR share price and reputation may be damaged.
5
Corporate Reporting
Disclosures
SAMPLE QUESTION
We Build Em Incorporated is one of the largest construction companies in the country. After
a lengthy and costly tendering process the company has been awarded a contract to build
1,000 houses for the local government over the next four years. The project will take three
years and the local government will pay $100,000 per house. The company spent $100,000
in accountancy and legal fees when applying through the local government's tendering
process. Each house will cost $60,000 each to build and ownership will transfer upon
completion of each house. The payment schedule is 7% of the Sale price when the project is
started 80% when the project is 90% complete and the final 13% is payable upon
completion of the entire project. If We Build Em Inc fails to meet their contractual
obligations they will be obliged to pay the local government $100,000.
There is a summary of the project work undertaken and payment schedules from year 1 to 5
below.
6
How do you record the revenue?
Have the conditions for this contract to be recognised under IFRS 15 been met?
1. Has each party’s rights in relation to the goods or services to be transferred been identified?
Yes
2.Has the payment terms for the goods or services to be transferred been identified?
Yes
Yes
4. Is it probable that the consideration to which the entity is entitled to in exchange for the
goods or services will be collected?
Yes
Note: If only some of these conditions were satisfied the company must monitor the situation
year on year and when these conditions of a contract are met IFRS 15 will be applied.
The company has promised 1,000 houses over the next four years.
Step 3: Determine the transaction price
What about variable consideration? IFRS 15 limits the variable consideration recognised,
it is only included in the transaction price if, and to the extent that, it is highly probable
that its inclusion will not result in a significant revenue reversal in the future when the
uncertainty has been subsequently resolved.
Step 4 Allocate the transaction price to the performance obligations in the contracts.
In this contract, there is only one obligation, build houses so the transaction price is
clearly linked.
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Step 5: Recognise revenue when the company satisfies their performance obligation.
“The company spend $100,000 in accountancy and legal fees when applying through the local
government's tendering process.” These expenses should be expensed in the year incurred.
Why?
They were not incurred due to the company's success at the tender
What if the expenses were recoverable? Then recognise the cost as an asset and amortise on a
systematic basis consistent with the pattern of transfer of the houses.
Year 0
There is no income
Year 1
Dr Bank $7 million
No revenue has been recognised and no expense has been recognised. It is all recognised on
the balance sheet or the statement of financial position.
8
Year 2
550 houses were completed since the local government gets the benefit and use out of the
asset as soon as building is complete revenue is due.
$48 million
Year 3
9
The balance of the Debtors in the Statement of financial position at the end of year 3 is:
$83 million
Total $3 million
$26 million
Total 5 million
Year 4
100 Houses uses are built so revenues of $10 million are recognised.
10
The company received its final payment of $13 million from the local government.
Dr Expenses $6 million
DISCLOSURES
The purpose of the disclosure is to disclose enough information for users to understand the
nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with
customers.
“In Year xx We Build Em Inc entered into a contract with the local government to build 1,000
new buildings. The total value of the contract is $100 million payable over four years. The
project is expected in year xxx.”
Include any assets recognised from the costs to obtain or fulfil the contract;
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Non-current assets
This section examines a practical application of the standards that deal with Non-Current
Assets:
20x6 was a busy year for ABC Inc a company in the communications industry. The following
transactions were undertaken:
They purchased a trademark from a company called “Call Me”. The trademark is valuable as it is
associated with high quality unique mobile phone devices. ABC will continue to sell mobile
phones under this trademark. The financial controller is very happy with the acquisition and
believes this asset is one “that will keep giving ABC returns forever.” However, the trademark
was given a ten-year life span. Its purchase price was $1 million. At the end of 20x7, a
competitor began to sell mobile devices like those under the “Call Me” trademark. At the end of
20x7, the recoverable amount of the trademark was $400,000. ABC plans to continue selling
phones under this trademark into the future
How is the trademark accounted in the financial statements of 20x6 and 20x7?
SOLUTION
Identifiability
Control
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capable of being separated and sold or transferred etc.
arising from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Historic cost
or
Revaluation cost
Intangible Assets
The Statement of Profit and Loss for the year ended 20x6
Expenses
Journals are
Cr Bank $1 million
In the financial statements for the year ended 20x6, it was $900,000.
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The asset is impaired and must be recognised at $400,000 in the financial statements for the
year ended 20x7.
Intangible Assets
The Statement of Profit and Loss for the year ended 20x7
In 20x6 ABC Inc bought the “Call Me” trademark for $1 million.
This is recognised as an intangible asset under IAS 38. Its useful life is valued at ten years and it
is amortised accordingly. The amortisation is expensed in the statement of Profit and Loss as
Amortisation of Trademark.
Purchased at $1,000,000
Amortisation ($100,000)
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The “Call Me” trademark is an intangible asset owned by ABC Inc purchased for $1million in
20X6. Its useful life is valued at ten years and it is amortised accordingly. The amortisation is
expensed in the statement of Profit and Loss as Amortisation of Trademark.
20x7
Purchased at $1,000,000
Accumulated Amortisation ($100,000)
Current year amortisation ($100,000)
Impairment losses ($400,000)
Carrying value $400,000
Disclosures IAS 36
At the end of 20x7, the “Call Me” Trademark was impaired due to a competitor offering It was
impaired by $400,000.
So Sushi Inc is a thriving business that owns one building where it operates a sushi restaurant
from, a warehouse which is used to prepare fish either for the restaurant or to sell wholesale to
supermarkets. It also owns another building which the business doesn’t use but rents to a local
business.
In 20x7 So Sushi Inc decides to close down its warehouse operation as because they purchase
new machinery. Now all the wholesale fish preparation can be done in the restaurant kitchen
on quiet mornings. The warehouse is valued at cost in the financial statements at $500,000 the
price they paid twenty years ago. It is not considered a depreciable asset. The directors have
decided to put the building on the market. They have had it independently valued at
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$1,000,000, the costs to sell are estimated to be $50,000. The warehouse has not been sold by
year end, however, there are a number of interested parties.
Their rental building was purchased at $500,000 two years ago, however, house prices have
fallen since then and the building is worth $400,000 at the end of 20x7. The directors have no
intention to sell as they are satisfied with the rental income generated by the property,
currently, it is generating $30,000 per year. The property is not depreciated as the company
policy is not to depreciate property and $10,000 was spent in the year on routine repairs.
In 20x7 the company buys fish processing machinery meaning that the preparation now only
takes a fraction of the time and space that it did before. The machinery cost $1million,
however, the organisation received a 10% discount for early payment. The useful life of the
machinery is 5 years and the company policy is to charge depreciation in the year of acquisition
and none in the year of disposal.
How will this be reflected in the financial statements of So Sushi Inc for the year ended 20x7?
SOLUTION
To be considered as a noncurrent asset held for sale under IFRS 5 the following conditions must
be met:
The sale is highly probable, within 12 months of classification as held for sale
The asset is being actively marketed for sale at a sales price reasonable in relation to
its fair value
The actions required to complete the plan indicate that it is unlikely that plan will be
significantly changed or withdrawn.
In the question, the warehouse satisfies these conditions and it is classed as a noncurrent asset
held for sale under IFRS 5.
Under IFRS 5 the valuation is the lower of the carrying amount and the fair value less costs of
sale.
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The carrying amount of the warehouse is $500,000
Disclosure
So Sushi Inc is selling its warehouse as the operations have moved to the restaurant building
and the warehouse is no longer needed.
The warehouse is currently on the market and there are a number of interested buyers. Sale
completion is expected in early 20x8.
Under IAS 40 an investment property is property held to earn rentals or for capital appreciation
or both.
Valuation
Under IAS 40 the Cost or the fair value model can be used to value the investment property. In
this solution, we will use the cost although both can be used.
So Sushi Inc holds an investment property that is currently rented to an unrelated party. The
property is valued in the financial statements at cost. The fair value of the investment property
is $400,000.
17
Under IAS 16 Items of property, plant, and equipment should be recognised as assets when it is
probable that:
the future economic benefits associated with the asset will flow to the entity, and
These conditions are both satisfied in the question. Therefore it I recognised as an asset under
IAS 16.
cost
or
revaluation
The cost was $1,000,000 less discounts of $100,000 therefore the value is $900,000
The machinery has a useful life of 5 years. The assets should be depreciated over their useful
life since no residual value was given I will assume a nil value. $900,000 / 5 = $180,000 this is
the annual depreciation charge.
Expenses
Depreciation $180,000
For each class of property, plant, and equipment, the following needs to be disclosed:
The gross carrying amount and accumulated depreciation and impairment losses
A reconciliation of the carrying amount at the beginning and the end of the period,
showing:
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Additions in the year
In 20x6 $900,000 of food preparation plant and machinery were purchased, net of trade
discounts. This is recorded in the financial statements at cost.
Depreciation $180,000
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Reporting the financial performance of entities
Financial Instruments
This is a technical area of the syllabus and one of those areas that candidates often struggle
with. There are a number of accounting standards that financial instruments influence.
Some of those instruments are recorded as debt and some of those instruments are recorded
as equity and the basic point to keep in mind is why does it matter whether something is
recorded as debt or equity.
Generally speaking, where we have a higher level of gearing, we are said to carry a
higher level of risk and this impacts on the weighted average cost of capital of the
business. It will go up and thus if we now face a higher weighted average cost of
capital.
We will have to undertake projects which generate a higher level of return too.
Ultimately therefore the classification of debt versus equity can impact on the strategy that the
company is following.
Preference shares
With preference shares, although the legal form of the instrument is that it is a share. The
substance is often that
it is debt. It is a liability and that's because the company is under obligation to pay the
preference dividend.
If the preference dividend is cumulative, or the preference share itself is redeemable that
obligation exists and we record our preference share as debt:
Debit to cash
Credit to liability
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We are essentially treating the preference share as a loan.
The banks will often monitor interest cover which is the amount of times an
operating profit covers the interest charge and, of course, if the preference
dividend is going through the finance cost, your interest cover will show adverse
movement.
Convertible debts
Another common instrument convertible debt. This is quite simply a loan which could be
converted into shares and from an accounting point of view, we need to understand whether to
classify this as debt (because it is a loan) or shares (because it is equity).
We do split account here. The convertible debt into its two component parts, we are actually
going to record some as debt and some as equity and will do this in line with the conceptual
framework.
Example
Imagine a £2 million loan, which could be converted into shares. Imagine there is a 6% coupon
rate on this loan. This means that the physical annual payments are (2 million x 6% =) £120,000
each year. So in terms of physical cash flows, we would have to pay £120,000 in three years.
and at the end of year three we will repay the principal of £2 million.
We take these physical cash flows and discount them back to their present value. The rate at
which we will discount is the prevailing market rate of straight debt with no right of conversion.
In other words, what we are trying to do is to treat this part of the instrument as if it was simple
debt, so it makes sense to discount using whatever the market rate for this type of debt is.
21
In this example, let’s assume the market rate for a similar debt is 9% and we assume the
principal is repaid at the end of year three:
DR Cash 2,000,000
CR Liability 1,848,122
CR Equity 151,878
We need to be able to go beyond calculating this and actually comment on the implications, if
you finance with an instrument which is convertible you can see you have added to both debt
and equity, but the impact on debt is relatively higher as compared to the addition in the
equity. So the impact of that is that it will cause your gearing to increase.
1. Measurement
You have to identify the business models that the company follows; there are three business
models that we could have:
Now imagine a typical bank, typical bank might have an investment section and it might have a
retail section, the retail bank typically just gives out mortgages to members of the public and
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collecting those contractual cash flows as they fall due. Everything in that part of the business
will be classified as hold to collect.
However, if you had an investment division, the investment division will be trading in financial
instruments, so everything in that division will be classified as help to trade.
Hold of collect
To understand it better, let’s look at another example; if Mr. A were to lend Mr. B money, as
Mr. B wanted a mortgage. Let’s suppose Mr. A lends the money for 20 years at a rate of 4% per
annum and all Mr. A is going to do for the 20 years is simply to collect in the contractual cash
flows as they fall due, but Mr. A is never going to trade this instrument or sell it. Here, fair value
is completely irrelevant. In which case, Mr. A us simply going to use an amortised cost to
measure the instrument.
Amortised cost
This is one area that students get stuck on but is a very simple measurement. It is calculated by
taking the original amount plus the interest less the cash.
Credit cash
Debit cash
Furthermore, don't forget that it is the effective interest which goes through the profit and loss
account, whereas, the coupon amount goes through the cash flow statement.
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Example
Imagine that the instrument had a 10% coupon. We make an investment of $100,000 and we
received (100,000 x 10% =) $10,000 in annual cash payments each year and thus we also get
our $100,000 back at the end. The only way in which we are earning money on this investment
then is through te $10,000 annual coupon and this gives us an effective interest rate of 10%.
Here the amount of interest going through the profit and loss account each year is 10,000;
which is equal to the amount which is going through the cash flow statement as well.
Discount
Let's now imagine that in addition to earning money via the annual coupon. The instrument was
also issued at a discount. To make it look more attractive to the investor, they only had to give
the investee $90,000 upfront. The investor has earned $10,000 because the instrument was
issued at a discount.
Now, in addition to that, they will also earn the annual $10,000 coupon rate per annum. At the
end, although the only originally gave up $90,000, they will receive back their $100,000. In
short, here we are earning money from two sources, the discount and the interest payments.
We actually have to calculate the effective rate. In other words, we have to spread the entire
earnings of the instrument over the life; this gives us an effective rate of 13%. To calculate the
effective interest rate, we need to find the IRR of the cash flows.
Year 1 = $10,000
Year 2 = $10,000
Year 3 = $10,000
Year 4 = $110,000
PV of cash inflows at 10% = $10,000 x 0.909 + $10,000 x 0.826 + $10,000 x 0.751 + $110,000 x
0.683 = $100,000 NPV at 10% = $100,000 - $90,000 = $10,000
PV of cash inflows at 15% = $10,000 x 0.869 + $10,000 x 0.756 + $10,000 x 0.657 + $110,000 x
0.571 = $85,725 NPV at 15% = $85,725 - $90,000 = $4,275
Premium at redemption
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Now it is possible that in addition to earning money at a discount ($100,000 instrument issued
for only $90,000) and earning money at a coupon rate ($100,000 investment pays an annual
$10,000 of interest), instrument also earns money because it is redeemed at a premium. So,
there is a premium on redemption, rather than getting back the $100,000, let’s suppose we get
back $105,000.
The total cash flow we will receive in the redemption year will be $115,000. Which is made up
of the original investment (100,000) plus the annual interest (10,000) and a premium (5,000).
Now we are earning from:
Earning the coupon which happens throughout the life of the instrument
Earning some from the premium on redemption which happens right at the end
As we do with depreciation on property, plant and equipment, we ignore when these amounts
actually occur and just spread them over the life of the instrument and so this works out at an
effective rate of 14% (we will do this by computing the IRR in the same manner as we did
above).
Interpretation
So we can see that if the coupon rate is the only way in which we are earning money on the
instrument, then the amount going through the profit and loss account and the cash flow will
be the same because we are earning $10,000 per annum and we are receiving $10,000 per
annum.
However, if the instrument is issued at either a discount or redeemed at premium, we can see
that the annual coupon remains at $10,000. In other words, was still receiving $10,000 per
annum. But the effective interest rate will be higher than that because we are spreading the
earnings from the discount and the premium over the life of the instrument.
However, let's imagine that Mr. A lends Mr. B money at 4%, but someone else comes along and
wants to borrow similar sum of money, but they're prepared to pay Mr. A 6%. Mr. A might be
the sort of investor that would sell the original investment and swap it for the more attractive
alternative one. So now Mr. A has a business model which is both hold to collect and hold to
trade. If the more attractive alternative, at 6%, had not come along, Mr. A would have simply
collected in the contractual cash flows of the 20 years and that will be a hold to collect business
model. However, because the more attractive alternative has come along at 6%, Mr. A is going
to sell the original investment and swap it for the more attractive alternative. Now, given that
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we might be in a position where we are trading this instrument, we ought to measure it at fair
value, so we would still apply amortised cost but at the end of the year we would do a fair
value adjustment. The fair value movement will go through OCI.
Essentially, what we're doing is creating a revaluation reserve within equity for our financial
instrument.
Hold to trade
Now back to the investment division where instruments are just simply being traded, in this
case we ought to be measuring at fair value. The fair value movements will go through the
profit and loss account because we are actually trading in those instruments. Even if we haven't
actually sold them at the end of the year, the intention is we will sell them shortly thereafter.
So by putting the fair value movements through the profit and loss account, we are holding the
directors directly accountable for their performance,
Summary
2. Hedge accounting
Typically hedge accounting will involves derivatives and there are three types of hedge
accounting. There is:
Of course, we are betting on an underlying variable at a future point in time and technically all
derivatives should be measured at fair value through profit and loss. Also note that you can
have derivatives in the business (forwards, futures and options), but you can choose not to
apply hedge accounting. You can simply measure those derivatives at fair value through profit
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and loss. All hedge accounting is essentially doing is, playing around with the accounting period
in which the movement on the derivative actually hits the financial statements.
Criteria
2. We also want to make sure that the credit risk does not dominate in other words, if I
am concerned about the price of coffee and I have a derivative which is based on the
price of coffee, then the movements on that derivative should be driven by the pricing
of the underlying variable rather than the credit rating of the party that actually issued
the derivative.
3. We also want to see that the hedge ratio is consistent with risk management strategy.
A futures market derivatives come in standard block sizes. So, for example, I might be
out to buy blocks of 10,000 coffee beans. My business problem is 96,000 coffee beans,
but the futures are available in block sizes of 10,000 beans. There will be some
ineffectiveness, I've got two choices; 96,000 ton business acquisition of coffee beans
could be hedged with either 90,000 of derivatives, or 100,000 of derivatives. In order to
apply hedge accounting, the amount of derivative should be consistent with the
exposure.
Example
We are concerned about a future sales for an entity that functions in GBP and making a sale
into a European market (EUR). They will be receiving revenues in EUR. Our business problem is
adverse movement of foreign exchange rates. There is a highly probable future receipt and we
are going to try and hedge this transaction. Let's imagine that it turns out that the amount of
revenue that is actually going to be receive has fallen by 10.
The good news is we anticipated this might happen and we took out a derivative that bet on
the GBP – EUR exchange rate. In the same period of time, we see the gain on the derivative of
11.6 million.
Here we see a business problem of 10, as revenues are going to go down by 10; we see a gain
on the financial asset of 11.6. This is pulled down into reserves, it doesn't go through the profit
and loss account. Now, however, the last (11.6 – 10 =) 1.6 gain on the derivative go to the
income statement because it's not actually protecting against our business problem that was
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only 10. As the last 1.6 again on the financial asset is not actually achieving anything, it is
credited immediately to the income statement.
So, in summary, we now have 10 sitting within a cash flow hedge reserve. We will hold it until
we actually make our sales that we were concerned about.
We have 10 saved up in reserves, we release it into the income statement and thus with an
extra 10 being credited to the income statement, this takes up the profit to 30 which is in line
with the original expectation:
Take the movement on the effective element of the derivative, defer it down into reserves and
carry it forward and release it to the income statement in the year when the business problem
actually happens.
How does a fair value hedge differ from a cash flow hedge? Cash flow hedge is concerned about
a future, then the fair value hedge is concerned about something which is happening now. In
other words, our business problem is already recognised in the financial statements.
Example
We could be concerned about fluctuations in the valuation of inventory. Let us imagine that we
typically have barrels of oil and we were concerned about fluctuations in the value of the
inventory of oil. We may take out a derivative to protect against those fluctuations, and as we
know all derivatives have to be measured at fair value through profit and loss.
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Let's imagine that in the year we see a loss on the derivative, so this would involve:
We take our recognised asset in this case, inventory, and we remeasure it to fair value. Let's
imagine that the price of inventory had gone up, so we would:
Note:
You might see the phrase firm commitment, a firm commitment is something which is legally
binding. So for example if you are actually going to go and buy an aircraft in the years’ time you
would have to sign a contract to do this, after which you will be under legal obligation to
purchase. A firm commitment is legally binding, therefore, a highly probable future forecast
transaction may still not occur, but a firm commitment has to occur. So where we have highly
probable forecast future transactions, we use cash flow hedges, but where we have a firm
commitment, we can apply fair value hedge.
3. Impairment
IFRS 9 has a proactive approach to impairment rather than reactive approach. Now what does
that actually mean? While the old standard IAS 39, was very reactive, in other words, we
actually had to wait for there to be objective evidence of impairment before we could put
through an impairment loss.
Imagine Mr. C loaned Mr. D money at an effective interest rate of 10%. Me. C is contractually
entitled to receive 10% from Mr. D each year on initial investment of a $100,000, with the
principal back at the end of the term. Under the old standard, we would have recognised
finance income at that rate of 10%, but in the year of default, we would have recognised the
huge impairment loss that what we call a reactive system we wait for the impairment to occur.
IFRS 9 moves against this and actually has a proactive system of impairment. So although we
might be legally entitled to receive 10% per annum. IFRS 9 has us anticipate how much we will
actually think we will receive, which is a case of professional judgement. Let say Mr. C thinks he
is going to receive the contractual amount of $10,000 in the first year, but then predicting
economic downturn in years 2, 3 and 4 and, thus, the receipts will be:
Year 1: 10,000
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Year 2: 7,000
Year 3: 7,000
Year 4: 5,000
Total: 29,000
Now we would recalculate the effective interest rate and taking those anticipations into
consideration. If you compute the IRR of the instrument, you can see that the effective interest
rate comes down to 7%.
So even though Mr. C is contractually entitled to receive 10%, we will use an effective rate of
7% throughout the life of the instrument and thus it smooths out the effect of any impairment
that might arise. The idea is that it does smooth out the effect of any impairment, thus, gives
better financial reporting.
Now how do we guess the future? It is very much professional judgement, you often hear the
phrase historic loss rate, this means use the past as a way of actually anticipating the future.
The company might, for example, have a historic loss rate of 3%. We could apply that 3% to
future cash flows. Rather than just apply the historic rate, we will think about whether we need
to modify it for any information that we have now or we have regarding the future. So
historically we might have used a 3% rate, but if we believe the future is going to be worse than
the past, then maybe we use 3.2% as an example.
Now the question is, once we've calculated that historic loss rate what cash flows do we apply it
to work.
The first model that we start off with, is called a 12 month model and in a 12 month
model, there has not been a significant deterioration in credit rating of the original
investment. And that means that the risk that we were willing to set to accept at
the start has not really changed and there's not really much risk of anything going
to wrong in which case, then we need only apply this historic loss rate to cash flows
over the next 12 months. However, since initial recognition, if there has been a
significant deterioration in credit rating, then there is a much higher risk of things
actually going wrong.
So rather than applying that historic loss rate cash flows over the next 12 months.
We will apply that historic loss rate over the lifetime of the model, which of course
would result in a much bigger impairment.
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Note:
There is no strict definition of what is meant by significant deterioration in credit rating and
different organisations may interpret this differently, therefore, this really is a matter of
professional judgement and whether or not you use a 12 month model for a lifetime model is
something which is going to be open to a lot of scrutiny.
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