GAAP: Measurement of basic financial instruments: old GAAP v FRS 102
A comparison of the measurement treatment of basic financial instruments between old UK GAAP and FRS 102, including the potential tax impact of the new standard.
Old UK GAAP
For entities not required or opting to apply FRS 26, old UK GAAP included limited requirements in respect of recognition and measurement of financial instruments.
FRS 4 dealt with recognition and measurement of financial instruments presented as debt/liabilities under FRS 25 (for example loans received, bonds issued, certain types of preference shares etc.). The FRSSE had equivalent provisions to FRS 4.
FRS 25 dealt with the presentation of financial instruments, notably with the classification of financial instruments as financial assets, financial liabilities or equity instruments. The FRSSE included similar provisions to FRS 4.
No standard under old UK GAAP dealt with financial assets such as current or fixed asset investments in shares or bonds, loans made and receivables.
The Accounting Regulations (S.I. 2008/410 and S.I. 2008/409) include measurement provisions in respect of fixed and current asset investments (such as listed and unlisted securities and long-term loans) but do not include specific provisions for other financial assets not classified as investments (like receivables).
Under old UK GAAP the accounting treatment of financial instruments not covered by standards or statute was therefore determined by prevailing practice.
FRS 4 and the FRSSE required debt (liabilities) to be initially recognised at the value of the proceeds received less the costs directly incurred to raise the debt. The finance costs of the debt, ie total payments to be made less net proceeds, was then allocated over the term of the debt at a constant rate over the carrying amount. In turn the carrying amount was increased by the finance costs for each reporting period and reduced by payments made in that period.
Under the Accounting Regulations, investments should be carried at historic cost less diminution in value.
Investments may also be measured in accordance with the alternative accounting rules, which involve taking revaluation surpluses to a revaluation reserve and not through the profit and loss.
The Accounting Regulations also allows investments, and other financial instruments including derivatives, to be carried at fair value with changes in value going through the profit and loss account. However, entities taking this option were required to apply FRS 26.
Some complex financial instruments, like derivatives, were not recognised under old UK GAAP if an entity was not applying FRS 26 but were only required to be disclosed in certain circumstances.
FRS 102 includes separate accounting requirements, outlined in two different sections of the standard, for ‘basic’ and ‘other’, more complex, financial instruments and transactions. The requirements for basic financial assets and liabilities are relevant to all entities. If an entity only enters into basic financial instrument transactions it will not need to apply the section of the standard that deals with more complex financial instruments.
FRS 102 also allows an entity to apply the recognition and measurement provisions of IAS 39 or IFRS 9 to all its financial instruments rather than the corresponding provisions in the standard.
Basic financial instruments normally include:
a) cash and bank accounts
b) trade and other accounts receivables and payables
c) loans from banks or other third parties
d) loans to and from subsidiaries and associates or to other third parties
e) bonds and similar debt instruments
f) investments in non-convertible preference shares and in non-puttable ordinary and preference shares
g) commitments to receive or make a loan to another entity that cannot be settled net in cash.
Examples of more complex financial instruments include:
a) options and forward contracts b) interest rate swaps c) investments in convertible debt and convertible preference shares d) investments in another’s entity equity instruments other than non-convertible preference shares and non-puttable ordinary and preference shares e) rights, warrants and futures contracts.
Basic financial instruments are required to be measured in different ways depending on the type and characteristics of the instruments:
a) Debt instruments such as bonds, loans etc. will be measured initially at present value of future payments and subsequently at amortised cost using the effective interest method.
b) Debt instruments that are payable or receivable within one year, typically trade payables or receivables, will be measured, initially and subsequently, at the undiscounted amount of the cash or other consideration expected to be paid or received. However, if the arrangement constitutes a financing transaction, ie the payment of a trade debt deferred beyond normal business terms or financed at a rate of interest that is not a market rate or in case of an outright short-term loan not at market rate, the financial asset or liability will be measured, initially and subsequently, at the present value of the future payments discounted at a market rate of interest for a similar debt instrument.
c) Debt instruments may also be designated by entity to be measured at fair value through profit or loss in certain specific circumstances.
d) Investments in non-convertible preference shares and in non-puttable ordinary and preference shares should be measured:
at fair value with changes recognised in profit or loss if the shares are publicly traded or their fair value can otherwise be measured reliably
at cost less impairment for all other investments.
Financial assets that are measured at cost or amortised cost shall be assessed for impairment at the end of each reporting period.
Other complex financial instruments are required to be measured at fair value with changes in fair value recognised in profit or loss except for:
a) investments in equity instruments that are not publicly traded and whose fair value may not be reliably estimated which shall be measured at cost less impairment and
b) hedging instruments for which the entity is applying the hedge accounting provisions in FRS 102.
The changes introduced by FRS 102 have a major impact on the accounting treatment of financial assets. In particular some debt instruments, like bonds and loans, could have been carried at historic cost or valuation under old UK GAAP, while FRS 102 includes a specific requirement to measure them at amortised cost using the effective interest method, which represents the present value of the future cash flows of the financial asset discounted to the carrying amount of the financial asset using the interest rate that exactly produces such result, ie the effective interest rate. The effective interest rate is determined by discounting expected cash flows, like interest payments, repayments of principal, fees, finance charges, premiums, discounts etc., to the carrying amount of the financial asset initially recognised, ie the transaction price of the asset.
FRS 102 also specifies the accounting treatment of debt instruments, both assets and liabilities, required to be settled within one year, which should be measured at the undiscounted amount of the cash or other consideration expected to be paid or received, unless they constitute a financing transaction. A financing transaction is typically one that does not include a stated interest rate or includes one that is not a market rate, such an interest-free loan or a trade debt payable beyond normal business terms.
Debt instruments in respect of such transactions are required to be measured, if materially different from undiscounted amounts, at the present value of the future payments discounted at a market rate of interest for a similar debt instrument. Old UK GAAP did not include such precise provisions for short-term financial assets and liabilities and the measurement requirements for financing transactions are likely to have a significant financial reporting impact.
Another significant difference introduced by FRS 102 is in respect of investments in shares. Under old UK GAAP such investments were normally carried at historic cost less impairment or at valuation with revaluation surpluses going to a revaluation reserve via the STRGL. Under FRS 102, investments in shares whose fair value cannot be reliably measured are carried at cost less impairment while those in publicly traded shares or shares whose fair value can be reliably measured are carried at fair value with changes via the profit or loss.
Effectively FRS 102 restricts the possibility of revaluing share investments to those that are reliably measurable in terms of fair value, possibly by reference to an active market, while under old UK GAAP revaluation was allowed under the more subjective judgement of the directors that can determine a value that appears to be appropriate to them in view of the company’s circumstances. Additionally under FRS 102 changes in the fair value of share investments are recognised in profit or loss and not via other comprehensive income as in the old UK GAAP.
The considerations outlined above will also apply for a small entity considering whether to adopt the FRSSE 2015 or the small entity provisions in FRS 102, as soon as they are available rather than wait for the period beginning on or after January 2016. That is the case because the FRSSE 2015 includes the same requirements in respect of measurement of basic financial instruments as the old UK GAAP.
Transition The general transitional procedures in FRS 102 will apply to financial instruments on first-time adoption, ie assets and liabilities will be recognised, reclassified and measured as at the transition date in accordance with FRS 102. For instance derivatives will be recognised if they were not recognised under previous GAAP and investments in traded shares will be re-measured at fair value if they were previously carried at cost.
An exception to the general transition rule is in respect of the derecognition provisions. Financial assets and liabilities derecognised under an entity’s previous accounting framework before the date of transition will not be recognised upon adoption of FRS 102. Conversely, for financial assets and liabilities that would have been derecognised under FRS 102 in a transaction that took place before the date of transition, but that were not derecognised under an entity’s previous accounting framework, an entity may choose:
to derecognise them on adoption of FRS 102; or
to continue to recognise them until disposed of or settled.
Taximpact As noted, FRS 102 introduces major changes to the rules for the reporting of financial instruments. The taxation of financial instruments is, to a large extent, covered by the loan relationship rules.
The computational rules for loan relationships are set out in CTA09/PT5/CH3. The key principles outlined in section 307 and 308 of CTA09 are that the amounts to be brought into the corporation tax computation are the 'credits and debits' which:
taken together, ‘fairly represent’ the company’s profits and losses from its loan relationships, and
are computed in accordance with generally accepted accounting practice (GAAP).
The loan relationship regime relies heavily on companies’ accounts, with the accounting treatment determining, to a large degree, both the amounts taken into account for tax purposes, and the timing.
The derivative contract rules introduced in 2002 (now to be found in CTA 2009 Pt. 7) govern the tax treatment of companies which are party to certain options, futures and contracts for difference. Again, the credits and debits to be brought into account are, very broadly, those that are recognised in accordance with generally accepted accounting practice.
The changes introduced by FRS 102 have a major impact on the accounting treatment of financial instruments and, since the taxation treatment broadly follows the accounting treatment under GAAP, this will have a direct impact on the taxation treatment.
FRS 102 makes widespread use of fair value accounting, particularly for derivatives. This creates potential corporation tax volatility on restatement and on an on-going basis.
Some companies might not be aware that they are carrying financial instruments in the shape of interest-rate swaps, foreign exchange contracts, or options and hedges the banks may have added to their loan agreements. Loan contracts should therefore be scrutinised to establish if they involve any derivatives or other financial instruments, as this will complicate matters and trigger the need to apply the section of the standard that deals with more complex financial instruments.