Viewpoint: Time to take account of new derivatives regime

FRS 102, the long-awaited replacement of the UK’s Generally Accepted Accounting Practice, is due to come into place next January for most small and medium-sized companies with accounting periods ending 31 December 2015. Generally speaking, it brings smaller companies in line with larger ones.

While this new accounting standard is still to be finalised and D-day is almost two years off, the transition to reporting under the new regime starts now, with comparative figures required for balance sheet and profit and loss accounts. Thus, for entities that report on 31 December, the transition started on 31 December 2013.

A fundamental change for these companies will be the requirement to bring financial instruments such as derivatives and foreign exchange hedging instruments onto the balance sheet and recognise changes in their fair value in profit or loss. Quoted entities and those that issue listed debt instruments have been subject to this regime since International Accounting Standard 39 was implemented in 2001.

The first priority for affected companies will be to identify all hedging instruments and locate the documentation. The next step will be to value them and document their alignment and relationship with the exposures they are intended to protect.

Companies can obtain such valuations from their banks, but banks do not take into account the purpose for which valuations are required and rarely disclose the methodology. An independent adviser can provide such background as may be required to satisfy the auditor’s requirements.

Recognition of hedging instruments’ fair value  on balance sheets has two immediate consequences. The first is that the potential for greater volatility in reported results for gains or losses arising from changes in valuation will be reflected in companies’ earnings. But this can be avoided by hedge accounting, which is permitted as long as hedging instruments meet terms and conditions set out in chapter 12 of FRS 102. The caveat is that chapter 12 may yet be revised, so companies must be aware  of any potential amendments to the rules.

The second effect is on a company’s financial ratios, particularly the financial covenants in its loan documentation. If this documentation does not exclude the effect of changes in accounting requirements, the company may run the risk of breach of covenant.

This is quite complicated, particularly for property companies with very few transactions. Some companies are considering confining their hedging activities to fixed-rate loans only. Such loans are not derivatives, which they long predate.

While the fair value of the fixed-rate loan still has to be calculated, it is a disclosure item only, so the valuations do not have to be brought onto the balance sheet. Most banks will agree to document the fixed rate in a way that preserves the beneficial aspects of the equivalent derivative instrument.

Where swaps have been used for hedging, the lending bank is most likely to have provided the instrument. Subject to the bank’s agreement, it is possible to consolidate the floating-rate loan and swap into a fixed-rate loan, for which the question of hedge accounting would not arise. Where fixed-rate loans incorporate options,  we would expect the option to be bifurcated for valuation purposes and accounted for as though it is a stand-alone derivative instrument.

More sophisticated small and medium-sized enterprises may elect to account for derivatives by adopting the recognition and measurement provisions of IAS 39 and its replacement IFRS 9, as it applies to entities that report under the full IFRS. These entities must report the fair value of their derivatives according to the provisions of IFRS 13 and adjust the values to reflect their own credit standing and that of the bank counterparty.

In either case, the disclosure requirements and definition of what constitutes a complex financial instrument must come from Chapter 11 of FRS 102. With this section still being debated, it is an interesting time for those preparing their accounts.

Brian Phelan is an associate director at JC Rathbone Associates, which offers debt financing and hedging advice