B6: Financial instruments and new international-styled accounting

1. B6: Financial instruments and new international-styled accounting • Speaker: Jonathan Pryor • Partner, Assurance and Business Services • Smith & Williamson • Chair: Jonathan Dwyer • Head of Private Finance • Homes and Communities Agency

2. B6 - Financial instruments and accounting – the potential impactJonathan DwyerHead of Private Finance23rd October 2013

3. Impact of economic and accounting changes on the sector Economic - What is the interest rate mix and how long is it fixed for? Accounting - What debt and interest rates in the sector are subject to changes in fair value? Sector Risk Profile 2013 Inflation £1.6bn Interest rate derivatives £9bn Cancellable / LOBO £4bn Caps / Swaptions £0.8bn Slide 2

4. The sectors change in fair value on derivatives has been dramatic..! LHS shows the MTM liability owed by HAs to banks on interest rate derivatives This is split between the unsecured threshold, property and cash collateral, except prior to September 2011 when the collateral is not separated. RHS shows the 15 years swap rate which is a proxy for the average term of the sector’s interest rate derivatives Slide 3

5. Interest rate mix… Slide 4

6. Economic: How much of the debt is really fixed..? Slide 5

7. FRS 102 and Financial Instruments Jonathan Pryor 23 October 2013

8. Disclaimer This seminar is of a general nature and is not a substitute for professional advice. No responsibility can be accepted for the consequences of any action taken or refrained from as a result of what is said.

9. Contents • Background • Overview of financial instruments under FRS 102 • Some examples

10. Setting the scene • The most widespread and fundamental financial reporting change in the last 20 years • Issued on 14 March 2013 by FRC • Replaces UK GAAP and the suite of existing standards with one all encompassing standard • ‘Modernises and simplifies financial reporting for unlisted companies and subsidiaries of listed companies as well as public benefit entities such as charities’ (Roger Marshall, FRC Board member and Chairman of its Accounting Council) • Broad thrust is to bring UK GAAP closer to full IFRS but in a practical way • Applies to all entities unless: • eligible to apply FRSSE and choose to do so; or • required to apply EU adopted IFRS or choose to do so; or • certain eligible parents and subsidiaries applying FRS 101 (reduced disclosure framework for IFRS preparers)

11. Timing Early adoption permitted (periods ending on or after 31 March 2013) Opening balance sheet at the date of transition (1 April 2014) Comparative balance sheet (31 March 2015) Balance sheet for year of adoption (31 March 2016) Planning - ability to influence the outcome on key transactions Implementation – first mandatory FRS102 financial statements (periods beginning on or after 1 Jan 2015)

12. Financial Instruments • A very complex area! • In all instances the disclosures of Sections 11 & 12 of FRS 102 must be applied • In terms of recognition and measurement, there is an accounting policy choice between: • Section 11 and Section 12 of FRS 102 (note that slight modifications are in progress) • IAS 39 (as adopted for use in the EU) • IFRS 9 and/or IAS 39 (as amended following the publication of IFRS 9) • These choices may produce different results but all of them are difficult to apply and will require some training, documentation and analysis. For the purposes of this discussion, we have assumed you will choose section 11 and 12 of FRS102 (but have reflected the expected modifications discussed above)

13. Definition • We will start with the definition of financial instruments

14. Financial instrument • A financial instrument is a contract that gives rise to a financial asset of one entity and financial liability or equity instrument of another entity. • A financial asset is any asset that is: • Cash • an equity instrument of another entity • a contractual right to receive cash or another financial asset from another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity • A financial liability is a contractual obligation to deliver cash or another financial asset to another entity or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (For this purpose we have ignored further elements in both definitions dealing with an entity’s own equity instruments)

15. Note • This captures many instruments eg. inter-company loans, which may end up being recorded very differently

16. Next step Whether • Basic, non-financing transaction • Basic financing transaction • Other (very different accounting treatment for each item)

17. Initial measurement Basic Other Not a financing transaction Financing transaction

18. Basic definition • Cash • A debt instrument meeting specific criteria (11.9 and on next slide) (however note that this definition is under-going change) • Commitments to create such debt instruments provided cannot settle commitment net in cash • Investments in non-convertible preference and non-puttable ordinary or preference shares

19. Basic debt instrument (11.9) A debt instrument that satisfies all of the conditions in (a) to (d) below shall be accounted for in accordance with Section 11: • Returns to the holder are: • a fixed amount; • a fixed rate of return over the life of the instrument; • a variable return that, throughout the life of the instrument, is equal to a single referenced quoted or observable interest rate (such as LIBOR); or • some combination of such fixed rate and variable rates (such as LIBOR plus 200 basis points), provided that both the fixed and variable rates are positive (eg an interest rate swap with a positive fixed rate and negative variable rate would not meet this criterion). For fixed and variable rate interest returns, interest is calculated by multiplying the rate for the applicable period by the principal amount outstanding during the period. • There is no contractual provision that could, by its terms, result in the holder losing the principal amount or any interest attributable to the current period or prior periods. The fact that a debt instrument is subordinated to other debt instruments is not an example of such a contractual provision. • Contractual provisions that permit the issuer (the borrower) to prepay a debt instrument or permit the holder (the lender) to put it back to the issuer before maturity are not contingent on future events other than to protect: • the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or • the holder or issuer against changes in relevant taxation or law. • There are no conditional returns or repayment provisions except for the variable rate return described in (a) and prepayment provisions described in (c). (However note this is undergoing change)

20. Basic Latest position: • Discussions underway which may result in the FRC making changes to Section 11 • Likely to move towards a principles basis rather than rules based definition • Likely to widen the range of instruments classified as basic

21. Other Everything that is not basic eg. stand-alone swaps or particularly complex loans (to be clarified)

22. Three different accounting treatments

23. Financing transaction • A financing transaction may take place in connection with the sale of goods or services, for example, if payment is deferred beyond normal business terms or is financed at a rate of interest that is not a market rate.

24. Exceptions • Several, but for example: • Basic FT can be designated as FVTPL (fair value through profit and loss) if it reduces significantly an accounting mismatch

25. An example: scene setting • An RP originally entered into a £20m bullet repayment loan for 15 years at a fixed rate of 7% • 10 years into the loan period, all £20m is outstanding • Loan is classified as basic under FRS 102 • RP decides to refinance

26. An example (cont.) Note: • Basic FT, therefore prior to refinancing at amortised cost (normally) • Since market rate initially, carrying value of £20m (ignoring arrangement fees etc)

27. An example (cont.) • Lender agrees to accept £200k as a fee, provide £5m of new money and extend the life of the loan instrument by a further 15 years • In other words, the loan will now become £25m with a further 20 years to run

28. An example (cont.) • Suppose new rate of interest is 5% fixed and market rate is 3.5% (the higher actual rate reflects the 7% fixed rate from the original loan)

29. An example (cont.) • Let us assume all interest payments happen on the anniversary of the loan agreement plus bullet repayment

30. An example (cont.) How do we account for this? • If “substantially different terms” then need to derecognise existing loan and recognise “new” loan • No guidance on “substantially different terms” although we can use IAS 39 as guidance

31. An example (cont.) Assuming we are going to derecognise, then we will do the following: • Expense the £200k (treating it as an early settlement payment as opposed to an arrangement fee for the new loan, a possible alternative)

32. An example (cont.) • Initially record the new loan at the present value of future payments discounted by the market rate of interest (3.5%)

33. An example (cont.) • This calculation reveals a balance of £30,330,000 • Derived from aggregating each of the interest payments of £1.25m over 20 years and the bullet repayment in 20 years time, all discounted by 3.5%

34. Journal entries £m £m Dr SCI 0.2 Cr Cash 0.2 Dr Cash 5 Cr Loan 5 Dr SCI 5.33 Cr Loan 5.33

35. Subsequent treatment • At anniversary date, the RP pays £1.25m interest • However only £1.062m of this is recognised as an expense (3.5% x £30.33m) • The remaining £188k is deducted from the loan

36. A second example: other • New loan taken out for £10m with £300k arrangement fee • Loan is classified as other • Fair value at first reporting date is £10.5m • Fair value at next reporting date is £9.6m

37. Accounting treatment • Expense the arrangement fee • Record loan at fair value

38. Journal entries First reporting date £’000 £’000 Dr SCI 300 Cr Cash 300 Dr Cash 10,000 Cr Loan 10,000 Dr SCI 500 Cr Loan 500

39. Journal entries Second reporting date £’000 £’000 Dr Loan 900 Cr SCI 900

40. Other • “other” loans are likely to be less common than basic • However all stand-alone swaps and derivatives are likely to be other and therefore at fair value with movements through SCI

41. Hedge accounting • This could produce a mismatch if, for example, a swap is intended to reduce interest rate risks on a basic loan instrument • In these circumstances, hedge accounting maybe helpful

42. Hedge accounting • Not necessarily the same as hedging from a treasury perspective • FRS 102 was very limiting • FRED 51: a much more permissive regime

43. Hedge accounting • Quite technical but enables recognition of movements in the income statement to be recorded at the same time

44. An example • An RP enters into a loan with Robber Bank plc on 31 March 2015. The loan balance is £10m (20 years, bullet repayment) and the interest rate is LIBOR+ 200 b.ps • On the same day the RP enters into ISDA swap (same nominal) exchanging LIBOR for a fixed rate of 5% per annum • At next reporting date fair value of the swap is £1m negative and fair value of the loan is £9.5m • Loan is classified as basic (assume) and swap is other

46. Example • However, suppose on 3 March 2015 the RP had elected to apply hedge accounting and documented this appropriately etc

48. Conclusions • Challenging area of accounting • Broader definition of FI • Three measurement bases • Watch initial measurement of basic FT • “other” volatility • Hedge accounting is an option (but take care)

49. Smith & Williamson LLP Regulated by the Institute of Chartered Accountants in England and Wales for a range of investment business activities. A member of Nexia International The word partner is used to refer to a member of Smith & Williamson LLP 25 Moorgate London EC2R 6AY Tel: 020 7131 4000 Fax: 020 7131 4001 www.smith.williamson.co.uk

50. FRS 102 and Financial Instruments Jonathan Pryor 23 October 2013