Under the new UK GAAP - FRS 102 - financial instruments are on the balance sheet from variable rate loans to currency forward contracts, warns Harris & Co accountants Northampton.

Financial instruments must be the least liked of all accounting topics. Shrouded in mystery and dread, they are even neglected by technical departments, shunted off to a team of experts who are both admired and feared.

And, up until now, this has not been a problem. Reasonably straightforward companies in the UK (no listing, no regulated business, medium sized or smaller) have only had to apply the accessible end of financial instruments accounting, using FRS 4, Capital Instruments, and then FRS 25, Financial Instruments: Presentation, too.

Admittedly, there was an adjustment period for many when FRS 25 came in, particularly with regard to understanding the differences between debt and equity: the fact that preference shares were not automatically ‘non-equity’ was hard for some to assimilate. Still, this was where it started and ended, and the topic of financial instruments could be put in a box and ignored.

It’s likely that some preparers who will be applying FRS 102, Financial Reporting Standard applicable in the UK and RoI, for the first time in their 2015 accounts are still of the view that financial instruments are nothing to do with them, but this could not be further from the truth: the requirements of sections 11 and 12 of the new standard are inescapable, and no one will be able to ignore them.

Basic or not?

FRS 102 introduces the concept of a ‘basic financial instrument’, which is usually held at amortised cost (see below) and is relatively straightforward.

But while the boards of simple companies may be of the view that they do not engage in complex activities, there are tripwires everywhere. All contracts that involve paying or receiving cash or shares (as well as some others) are financial instruments, and the details need to be reviewed for all of them.

This is because an apparently innocuous clause, such as an interest rate cap in a variable rate loan, can prevent an instrument from being classified as basic, meaning that it would need to be measured at fair value.

Getting amortised cost right

The requirement to record debt at amortised cost has been in place for a long time, as it was included in FRS 4, but for many preparers it has been possible to conveniently ignore it. For very simple debt, where the interest charge accrues and is settled each period, there is no accounting to do beyond recognising an interest expense and a cash outflow.

Under FRS 102, though, it is more likely that for some reason debt will initially be recorded at something other than its face value, meaning the interest charge recognised each period is not the same as the cash interest.

Perils of intercompany loans

In many groups, arrangements for cash to flow between group companies are informal, and often obscure. It is quite common for a group to have a number of no-longer-needed dormant subsidiaries, with lingering intercompany balances that have never been cleared down.

Under old UK GAAP, such balances were often left well alone, reconciled in a tortuous matrix at the year end, but otherwise ignored. Now, though, these loans will need to be revisited, and efforts will be needed to find documentation. If they are repayable on demand, and bear no interest, they can continue to be ignored, and if there are no formal terms then this would be the standard assumption.

But, if they have a repayment date in the future, then they need to be accounted for properly, including imputing a market rate of interest even if the contractually agreed rate is zero or very low. So one group company will recognise income, and the other an expense, even if no cash has changed hands in years, and there is no intention for the loan to be settled.

Derivatives

Most small companies go nowhere near derivatives, but some might be using them without really knowing it, for instance if they have foreign currency forward contracts or have entered into a supplementary agreement with a bank to fix loan interest, which actually takes the form of an interest rate swap. Because this sort of item would not have been on the balance sheet under old UK GAAP, they are easy to miss, but under FRS 102 they need to be recognised at fair value and remeasured every period.

Investments

Under old UK GAAP, investments in another company’s shares would usually just be left on the balance sheet at cost, with an occasional glance at whether an impairment review was needed. Now, though, those investments need to be checked for whether or not they count as basic – they will if they are in simple equity instruments, but perhaps not if there are any complex features to the shares, such as a guaranteed return, option to have them redeemed, or similar. Even investments classified as basic must as a default be held at fair value, though if this is not reliably measurable (as will quite often be the case for investments in small private companies) then cost less impairment will be used.

Source Accountancy Live