Caroline Rolfe Group Head of Financial Accounting 24 September 2007

1. HM TREASURY ROUNDTABLE ON MOVING TO INTERNATIONAL FINANCIAL REPORTING STANDARDSDfT’s approach to implementing IAS 32 Financial instruments: Presentation and 39 Financial instruments: Recognition and Measurement Caroline Rolfe Group Head of Financial Accounting 24 September 2007

2. Contents – DfT’s approach • Research • Discoveries • Uncertainties • Work plan

3. Researchphase • High-level classroom awareness training – first IFRS training event in November 2004 • Detailed read-through of IASs 32 and 39 (FRSs 25 and 26) • Review of the Department’s accounts – keep theoretical research relevant • Review of other entities’ accounts

4. Discoveries What types of asset/transaction are “financial instruments”? • Cash?  • Trade receivables/payables/accruals?  • Prepaid expenses?  • Property, plant equipment?  • Guarantees of another entity’s borrowings, bonds etc?  • Other contingent liabilities? 

5. Discoveries For DfT, many material arrangements may meet the definition of “financial instruments”: • Material loan debtors  “loans and receivables” • Guarantees of other entities’ borrowings  “financial guarantee contracts” • Some contracts’ cash flows vary in accordance with indices such as RPI  “embedded derivatives”?

6. Measuring “loan and receivable” balances • Initial recognition at “fair value”, then at “amortised cost” • Worked example: an entity makes a loan at the end of year 200X. Assuming no indication of impairment, what should it be valued at in the accounts as at the end of 200Z?

7. Financial guarantee contracts – an overview

8. Measuring “financial guarantee contracts” Initially, at “fair value”. Some approaches could be: • Third party obtains quotes on transferring the risk • Difference between the amount the company could borrow with and without the guarantee, or in interest rates payable • The value of any fee Subsequently, at the higher of “the amount initially recognised less cumulative amortisation” or the IAS 37/FRS 12 Provisions, Contingent Liabilities and Contingent Assets provision value.

9. Subsequent measurement of “financial guarantee contracts” contracts Worked example: A five-year loan is guaranteed by a third party. The guarantee’s initial value is £50,000; its maturity value £0. If the third party considers it less likely than not that the guarantee will be called, it will release the £50,000 liability systematically over its five year life, as “interest income” If, however, it considers it more likely than not the guarantee will be called, it will value the liability at the amount it will have to pay to the lender.

10. Uncertainties (1) One criterion for separating an embedded derivative is: if the economic characteristics and risks of the embedded derivative are not closely related to the host contract. If an embedded derivative is separable, it is measured at fair value. Many PFI contracts link payments to RPI in order to transfer the “potential change in relevant costs” risk to the operator. Is it consistent to argue that it transfers risk and that its economic characteristics are closely related to the host contract?

11. Uncertainties (2) • Adjusting the values of loan debtors where the term, interest rates and payments may be subject to renegotiation • Accounting for guarantees of another party’s interest rate hedge

12. Work plan • Resolve the issue of RPI as hedged derivative • Review contracts for embedded derivatives or other financial instruments • Expand review of other entities’ accounts (including counter-parties’ accounts) • Consider using external advice where this represents VFM