1. General
This quick guide may be useful for professional accountants in practice or those working in Industry or Financial services firms like Banks/FIs, to calculate IFRS values for certain common business contracts which are usually high valued and significant in business operations, into the financial statements. So, here we go!
2. How to get IFRS values –techniques
(a) Accounting of contingent liabilities like financial guarantee contracts (FGCs) under IFRS
Guarantees are commonly encountered in the commercial world; these can range from guarantees of bank loans made as accommodations to business associates
Under IFRS, a financial guarantee contract requires the issuer (insurance entity) of the contract to make specific payments to the contract holder (lender) for a loss incurred by the holder if a debtor (borrower) fails to pay under the terms of a debt instrument.
Examples which are FGCs: bank guarantees, letters of credit, credit default contracts, insurance contracts and cross-guarantees within a group structure. Examples which are not FGCs: joint and several liabilities arising under partnership law and under tax sharing agreements, which are statutory or legally based, and tax funding agreements.
If a contract transfers financial risk then it is a derivative. If insurance risk is involved, then the contract is accounted for under IFRS 17.
Basis of IFRS accounting an FGC under IFRS: IFRS 9 requires that all financial guarantees within its scope are measured initially at fair value and then subsequently at the higher of (i) that amount, less amortisation, and (ii) an amount that would be recognised as a provision in accordance with IAS 37.
Example of FGC accounting under IFRS:
On initial recognition of an FGC signed on 1.1.20X6 for a 5 year term in issuer insurer’s books D, premium receipt of say CU 500 paid by the third party E (the contract holder lender and borrower of a loan) which has been guaranteed against loss of CU 10,000 on default by E’s debtor Z (lender bank), would be debited to bank and a FGC as a financial liability would be fair valued at CU 500. On 31.12.20X6, debit FGC liability a/c and credit income a/c CU 100.
Subsequently, on 31.12.20X6, debit FGC liability a/c and credit income a/c CU 100. This liability has subsequently been amortised as income over the period of FGC (so far under IFRS 9); until say as on 31.12.20X7 credit market has deteriorated to such a degree that it has become probable that undertaking E will default on its loan to the bank it has become probable that the issuer insurer D will be required to pay E (the contract holder protectee). In such a situation, insurer entity will make a best estimate of the expenditure required to settle the obligation say on the balance sheet date 31.12.20X7. Assume D’s best estimate of the liability is CU 9,650, D will debit expense a/c 9,250 and credit FGC liability a/c 9,250 (9,650 – 400 balance in FGC liability a/c already existing).
There is no exclusion for intra-group financial liability contracts under IFRS 9 and the same treat and IFRS accounting will apply as given in the above example. Recap that FGC falls under IFRS 9 while once the probability of loss has been foreseen when a provision will be made in insurer D’s books under IAS 37 Provision, Contingent Assets and Contingent Liability, only to the extent of best estimate amount exceeds the carrying amount of FGC liability in the books.
Remember, if a contract transfers financial risk then it is a financial derivative and not FGC.
Perhaps you can realise how different it is to account for FGCs under IFRS as compared to GAAPs where a disclosure may be enough. The takeaway under IFRS is that a contingent liability needs recognition unless a contract is outside the scope of a financial instrument under IFRS 9 and therefore all business contracts should be analysed first suitably.
(b) Accounting of purchase commitment contracts (PCCs) under IFRS
A purchase commitment is a firm commitment to acquire goods or services from a supplier. Entities enter into purchase commitments in order to lock in a particular price, and sometimes also to lock in the production capacity of a supplier, which can be used as a defensive tool to keep competitors from using the production capacity.
Under GAAPs, commitments remain off-balance sheet with a disclosure. Under IFRS, if the purchase price decreases before the agreement is exercised, the commitment has the disadvantage of requiring the entity to purchase inventory at a higher than market price. If this happens, a loss on the purchase commitment is recorded. Remember, the loss occurs when the market price falls below the commitment price rather than when the inventory eventually is sold.
An example of a PCC
In July 20X1, Sony Inc., (the buyer) signed two purchase commitments. The first requires Sony to purchase inventory for CU 500,000 by November 15, 20X1. The second requires the entity to purchase inventory for CU 600,000 by February 15, 20X2. Sony’s fiscal year-end is December 31. Buyer uses a perpetual inventory system.
Contract Period within Fiscal Year:
Contract period for the first commitment is contained within a single fiscal year. Sony would record the purchase at the contract price if the market price at date of acquisition is at least equal to the contract price of CU 500,000.
If the market price at acquisition is less than the contract price, inventory is recorded at the market price and a loss is recognized. For example, if the market price is CU 425,000, the following entry records the purchase:
| Entry by Sony (buyer) | Dr CU | Cr CU |
| 10 Nov 20X1 -acquisition | ||
| Purchase (Inventory) A/C | 425,000 | |
| Loss on purchase | 75,000 | |
| To Payable A/C | 500,000 |
Objective of this treatment is to associate the loss with the period in which the market price declines rather than with the period in which Sony eventually sells the inventory. This is the LCM (lower of cost or market for valuing inventory) rule objective.
Contract Period Extends beyond Fiscal Year
Now let’s consider Sony’s second purchase commitment that is outstanding at the end of the fiscal year 20X1 (that is, the purchases have not yet been made).
If the market price at the end of the year is at least equal to the contract price of CU 600,000, no entry is recorded.
However, if the market price at year-end is less than the contract price, a loss must be recognized to satisfy the LCM objective of associating the loss with the period in which the price declines rather than with the period in which the buyer eventually sells the inventory.
Let’s say the year-end market price of the inventory for Sony’s second purchase commitment is CU 540,000. The following adjusting entry is recorded:
Unrealised MTM loss on Purchase Commitment (PC):
| 31 Dec 20X1 -Buyer | Dr CU | Cr CU |
| MTM loss on PC contract –include in Purchase (Inventory) PL A/c | 60,000 | |
| To Provision to purchase inventory above the market price at period-end (PC price-mkt. price) BS A/c | 60,000 |
At this point (reporting period-end), the loss is an estimated loss. The actual loss, if any, will not be known until the inventory actually is purchased. The best estimate of the market price on date of purchase is the current market price, in this case CU 540,000. Because no inventory has been acquired, we can’t credit inventory for the LCM loss. Instead, a liability is credited because, in a sense, the loss represents an obligation to the seller of the inventory to purchase inventory above market price.
Under GAAPs, purchase commitment contracts are not to be recognised!
(c) Accounting of Loan commitment contracts (LCCs) under IFRS
Importance of LCCs: over 80% of all commercial bank lending to corporations in the United States is done via bank loan commitments, yet we have little knowledge of loan commitment contracts (LCCs). Key difference between bank and capital market financing is that banks can negotiate the kind of long-term financing arrangements that aren’t available in capital market.
Loan commitment is whereby the borrower purchases the bank’s defined promise to provide a loan and lines of credit in the future at predetermined terms.
Loan commitment contracts must be recognised as a financial liability under IFRS at Fair Value. LCCs are usually disclosed merely as a contingent liability under GAAPs. Loan commitments provide the road map for a lending transaction.
Commitment fees are consideration for the promise to lend money. A bona fide commitment fee is not interest. Commitment fee is not an unenforceable penalty, but is a valid consideration for the lender entering into a loan commitment.
Commitment fee decided represents the fair value of an LCC for initial recognition of the liability contract.
There are two broad ways to account for LCCs under IFRS depending upon how the contract has been analysed:
1 Accounted as derivative contracts –scoped in IFRS 9 if (i) designated at FVTPL, (ii) can be net cash settled or by another derivative & no loan originates shortly after LCC and (iii) interest rate is below market rate.
2 Accounted as LCC –scoped out of IFRS 9, LCCs are issued as bona fide LCCs and are therefore brought to books as LCCs under other provisions of IFRS –IAS 37 Provision and IAS 18 revenue as commitment fee –usually the case -3 ways to record an LCC.
Entries for LCC as an Options Derivative under 1 above –scoped in IFRS 9
On issuance of a Loan Commitment Contract:
Bank A/c Dr
To Call / Put Option premium A/c
(For receipt of premium. Seller will credit the premium received in the P & L Account)
Call / put option sold A/c Dr
To Liability on call/put option sold
(Being recognition of asset & liability on option sold)
Cash Settlement
Liability on call/put option Dr
To Call / Put option sold A/c
(Being reversal of recognition entry)
Bank A/c Dr
To Profit on Options
(Settling Options contract in cash as the difference between spot price of U/L asset LCC and strike or exercise price of the Options contract), or
Loss on Options A/c Dr
To Bank A/c
(Settling Options contract in cash as the difference between spot price of U/L asset LCC and strike or exercise price of the Options contract)
Profit on options A/c Dr
To P & L A/c
(Being Profit on reversal of options contract sold)
(premium on bought – sold)
P & L A/c Dr
To Loss on options A/c
(Being Loss on reversal of options contract)
LCCs under 2 above –scoped out IFRS 9 but covered under IAS 37 Provision & IAS 18 Revenue
Method 1: LCC onerous cost of funding loan exceeds interest receivable –charge fee deferred to profit or loss immediately. Method 2: Loan disbursal probable –fee deferred & reduced from loan to get loan’s EIR. Book income on expiry of LCC, if loan isn’t made. If disbursed, Dr. LCC Liab, Cr. Income = unamortised bal. def. fee. Method 3: Loan not probable Fee deferred & book fee income over LCC period. LCC on initial recognition at fair value: Bank/LCC fee receivable DR, LCC liability CR. Fee. Fair Value = LCC fee.
Example of LCC under method 2 loan disbursal probable
Bank P provides housing finance to buyers of new apartments in bank approved projects. Bank charges a flat commitment fee of 10,000 for each loan application. The only cost that is directly attributable is a fee of 2,000 the bank pays to an analytical firm which assesses risk of the loan. In a particular case, the bank received an application for a loan of 2,000,000. Bank paid 2,000 to the analytical firm for assessing the risk in the loan. After due assessment of the risk and other processing, the bank has sanctioned the housing loan at an interest rate @10% p.a. The loan will be repaid in equal instalments over 120 months. Explain how bank P should account for the commitment fee received of 10,000.
Solution: The commitment fee receipt 10,000 adjusted for the transaction cost 2,000 should be classified as cash inflows at the date of disbursement of the loan to calculate the effective interest rate. Thus, the total cash outflows on the date of loan disbursal should be taken at 1,992,000 (2,000,000 – 10,000 + 2,000). Calculate the EMIs for total future loan repayments to Bank P @0.0083333% pm interest rate (10%/100÷12months =0.0083333% monthly), tenor 120 months. EMI =26,324.28. Use either an online EMI calculator or formula EMI= p x r x (1+r)n/((1+r)n-1) where p=principal loan amount, r=pro-rata rate of interest (e.g. annual rate 10% prorated to 1 month: 10/100÷12 months=0.0083333% monthly)., n=no. of EMI periods.
EMI= p x r x (1+r)n/((1+r)n-1)
1,992,000 x 0.0083333%/100 =16,600 (stated ‘EMI’ of principal loan only)
(1+r)n = 1.0083333 x 1.0083333 press 119 times =2.7070
(1+r)n – 1 = 1.2070
2.7070 ÷ 1.2070 = 1.5858
Stated principal EMI (1,992,000 ÷ 120 months) 16,600 or computed in step 1
EMI (principal + interest) 16,600 x 1.5858 = $26,324.28
You can calculate EMI for any loan or leasing transaction using above steps
Calculate EIR for 120 monthly instalments i.e. 1.005% for 120 periods –use online calculator
Discount 120 EMIs as FCFs of loan repayments 26,324.28 using EIR @ 1.005%. PV of EMIs will be different for all the 120 EMIs. The farther the EMI from today, the lower will be EMI’s PV.
Aggregate of PV of 120 EMIs will be the initial carrying value of the loan which when amortised using EIR of 1.005% will give the EIR based interest income. The 9th year end carrying value of loan (stated EMI of principal loan only 16,600 (=1,992,000 x 0.0083333%/100) plus 10th year EIR interest income will be equal to the stated interest income + stated EMI of 16,600 (1,992,000÷120 months).
Above procedure to apply if the loan is disbursed by bank. If loan is not disbursed, commitment fee of 10,000 be recognised as income on expiry of the LCC.
LCC accounting under IFRS is again highly complex, each step be documented but isn’t elusive. Some advanced knowledge of arithmetic (and not maths) is required to get to IFRS value.
(d) Accounting of highly probable forecasted transactions (HPFTs) under IFRS
Definition
When a transaction is expected to occur, yet there is no firm commitment, it is termed as a forecasted transaction. In other words, business entities anticipate a future transaction without any commitment in a forecasted transaction. A forecasted transaction is an uncommitted but highly probable future transaction. A forecasted transaction (with an external party) is one that is ‘probable’ or ‘expected to occur’ on a specific date but whose timing involves some uncertainty within a range?
Assessing whether a forecast transaction is ‘highly probable’ and/or ‘expected to occur’ requires a judgement based on facts and circumstances. IFRS 9 does not specify a quantitative threshold to define these terms. As a broad indicator, it is suggested that ‘highly probable’ might be interpreted as a probability of 0.9 (90%) or more, and ‘expected’ as more likely than not i.e. a probability of over 0.5 (50%).
In contrast, a firm commitment is a binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date (or dates).
Identification of forecast transactions
Identification of forecast transaction and economic exposure is done by combining internal sources (sales forecasts, purchase records, order books) and external sources of information (such as economic data) and applying a number of measurement techniques (e.g. sensitivity analysis, market scenario analysis, simulation analysis).
A sales budget on its own is generally not persuasive evidence for a forecast transaction being highly probable unless there is additional supporting evidence.
Accounting for forecast transactions
A forecast transaction is not accounted for under usual accounting or even disclosed under present accounting standards, unless a hedging instrument like a foreign currency forward exchange contract is taken in respect of a highly probable exposure or transaction being the hedged item. When you enter into a forward contract, it will have to be accounted for in the manner explained in succeeding points.
Example: Forecasted transactions are highly probable with a known notional and cash flow risk from an unknown (future) spot/market price or rate on a reporting date such a forecasted transaction remains anticipated. (Cash flow risk of loss 3 for a business =current date market price 100 – future anticipated market price 97).
Identifying a business contract correctly is very important to account for properly, to determine if a contract is a firm commitment or an HPFT? For example, if there’s a loan commitment to lend 10 million in six months, the loan is a firm commitment if the interest rate (underlying) is contracted in advance and a forecasted transaction if the interest rate is to be the current market (spot) rate on the date funds change hands.
If the price (underlying) is specified in advance at $3.90 per gallon before delivery takes place, then the contract is a firm commitment –gives rise to a fair value risk.
If Air India signs a purchase contract to buy one million gallons (notional) of jet fuel in 7 months from Indian Oil, the contract is a forecasted transaction if the price (underlying) of the jet fuel is to be the spot rate on the date the fuel is delivered –gives rise to a cash flow risk.
Accounting mismatch between receivables/payables and forecast transactions: When entities hedge FX risk they often use derivatives, such as FX forwards or FX options. Under IFRS, derivatives are recorded in the balance sheet (B/S) at fair value and the change in fair value is recorded in the P&L. The hedged assets or liabilities are usually measured at (amortized) cost or are forecasted items which are not recognized in the B/S. This results in a mismatch in the timing of the gain and loss recognition, creating possible P&L volatility. Hedge accounting modifies the normal accounting treatment of a hedging instrument and/or a hedged item, in order to recognize their offsetting changes in fair value or cash flows in profit or loss at the same time.
However, a highly probable forecast transaction can be established into a cash flow hedging relationship by designating the forecasted transaction as a potential hedged item.
Hedging is different to hedge accounting: The main purpose of hedging is from a business perspective. For example, FX risk management is one of the main activities to protect profitability. However, when entities manage business risk exposures from accounting perspective with the aim of achieving a zero FX result in the profit and loss statement (P&L), entity should first ensure if it is eligible to follow hedge accounting?
Hedge accounting is an accounting technique which remains optional and can only be applied to hedging relationships that meet the qualifying criteria under IFRS 9.
Cash flow hedging and changes to a forecast transaction
A highly probable forecast transaction continues to be eligible for cash flow hedge even if the expected timing of the transaction changes. However, guidance is required for an entity that designates a highly forecast transaction as a cash flow hedge and to highlight the accounting consequences if the:
- Timing of the transaction changes,
- Transaction is no longer considered highly probable,
- Transaction is no longer expected to occur,
- Transaction is expected to occur only partially.
Conversion of a forecast transaction into a firm commitment
If a hedged forecast transaction subsequently results in the recognition of a non-financial item or becomes a firm commitment for which fair value hedge accounting is applied, the amount that has been accumulated in the cash flow hedge reserve is removed and included directly in the initial cost or other carrying amount of the asset or the liability.
In other cases (for example, if it is decided to discontinue hedge accounting), the amount that has been accumulated in the cash flow hedge reserve is reclassified to profit or loss in the same period(s) as the hedged cash flows affect profit or loss.
Concluding comments
Analysing business contracts is the key to follow IFRSs correctly and in a significant way. The above write up may sound difficult and complex but reflects the ground reality professional accountants have to face in view of existence of common multiple business contracts which require to be sufficiently studied for a complete and proper IFRS accounting. Exclusion of any such business contracts by remaining off-balance sheet, by whatever reason, can have adverse & incorrect IFRS accounting consequences. This article brings out only some aspects of basic accounting under IFRS.
CA Anand Varma, a retired finance and accounting professional and can be reached at varma1002003@yahoo.co.in
