Book title: Understanding
Financial Markets & Instruments
Accounting for financial instruments and derivatives has always been a controversial issue. It seemed at one time as if nobody wanted to accept that there is a right and a wrong way. For a long time no accounting standards existed as far as financial instruments and derivatives were concerned. The United States has in the recent past been the leader in the field of accounting for financial instruments and derivatives. The American FASB issued several statements and concepts for the treatment of these instruments. The numerous issues on this matter resulted in a situation where different approaches were followed in practice.
The International Accounting Standards Committee (IASC) strives towards standardisation of the accounting treatment of all financial instruments. In November 1997, the IASC decided to develop an integrated and harmonised international accounting standard on financial instruments. This step was taken after the discussion paper on financial assets and liabilities issued in March 1997 by the IASC showed that a number of key matters still had to be resolved.
The discussion paper of the IASC and the American standards differed, in that
The IASC Board has had numerous discussions and publications on the matter and give guidelines on the treatment of derivatives, which will be included in an exposure draft resulting from the board meeting in April 1998. Some of the important features of the guidelines indicate
In South Africa a few statements have been issued which have an influence on the accounting treatment of financial instruments. Some of these statements are
AC108 - Inventories
AC120 - Disclosure in the financial statements of banks
AC 125 - Financial instruments; disclosure and presentation
AC 208 - Accounting for future contracts.
To be able to use these standards, it has to be established whether the instruments are held for purposes of trading or for non-trading purposes.
If instruments are held for trading purposes the question can be asked whether it could be classified as inventories and treated under AC 108. In most cases, however, the treatment of financial instruments as trading stock differ significantly from the treatment of trading stock as discussed in AC 108. Principles such as budgeting, re-order levels, activity-based cost computing, etc. could not be implemented for financial instruments. AC 108 also states that inventories must be measured at the lower of cost and net realisable value. This principle, however, is not globally used as far as trading portfolios of financial instruments are concerned.
Looking at AC 120, financial instruments are named separately in paragraph 09. This implies that financial instruments held for trading purposes could be classified neither as inventories as per AC 108, nor as investments. It could also imply that these instruments must be classified separately, and treated under the fundamental accounting principals.
AC 125 clarifies the guidelines that should be used in deciding whether to accrue for gains and losses on financial instruments. Detail concerning the disclosure of risks etc. are given.
AC 208 deals with the recognition of gains and losses on futures contracts and makes a distinction between futures utilised for hedging non-trading assets and other futures.
Due to the uncertainty and differences worldwide, there is no consistent treatment. Guidelines for the accounting treatment of financial instruments are, however, available in several statements issued world-wide, market practice and general, non-promulgated accounting rules. These guidelines will be followed when the accounting treatment of financial instruments is discussed below.
9.2 Valuation of financial instruments
One of the first problems that arise when accounting for financial instruments is to ascertain the value at which these instruments should be accounted for and disclosed in the financial statements.
In the opinion of the writer the first question to answer concerning valuation is whether the instrument purchased or sold short was for trading or short-term gain purposes, or whether it was for long-term investment purposes in general.
The two values at which financial instruments can be shown are thus
9.2.1 Historical cost valuation
According to the historical cost method, the asset or liability is shown at the monetary amount at which the asset or liability was acquired. If the asset has a nominal value, and it was acquired at a premium or discount, the premium or discount can be amortised over the period left to the redemption of the financial asset.
9.2.2 Reasonable value or fair value
To determine the reasonable value of an asset or liability, several methods can be used, depending on the nature of the asset/liability. This was previously known in the accounting as net realisable value, but was not defined in practice as far as financial assets are concerned. Some of the methods that could be used are discussed below.
22.214.171.124 Current market trading value
Where an asset is trading on a regular basis in a liquid market, the most recent market value can be taken as reasonable value. This would, for instance, be the case for listed equities, bonds, BAs, options, etc.
126.96.36.199 Net asset value
Where a financial asset is represented by different assets and liabilities, the net asset market value can in some cases be determined and used as an indication of the value of the financial asset. This would be the case for some shares.
188.8.131.52 Economic value added approach
This method discounts the economic value added for a company at an appropriate rate to establish the present value for shareholders.
184.108.40.206 Discounted cash flow using current market rates
Where an instrument represents a known cash flow stream, such as bonds, BAs, NCDs, etc. the cash flow can be discounted using current market rates for such an instrument, to arrive at a net present value of the cash flow.
220.127.116.11 Discounted cash flow using the yield curve
The yield curve constructed using current market rates, starting from overnight interest rates (short term) to long-term interest rates. The following is an example of a yield curve from the rates on the SARB Web pages in May 1998:
Where an asset represents a cash flow stream that is uncertain and is dependent on the movement in interest rates, this cash flow stream can be estimated using the current yield curve. Using rates applicable to the timing of the cash flow, the cash flow can be estimated. These cash flows can then be discounted using the yield curve rates or the current market rate. This method is often used with interest rate swaps. An asset with a known cash flow stream can also be discounted, using the yield curve rates that are applicable to the specific timing of the cash flow occurrence.
18.104.22.168 Valuation methods relating to specific assets
Certain mathematical formulas were developed to arrive at a reasonable value for specific assets such as options, futures, etc.
9.3 Accounting for equities
9.3.1 Equities as a long-term investment
Equities kept as a long-term investment can be kept at cost and the market value shown by way of note to the statements (method 1), or revalued and shown at market value (method 2). With method 2, the profit or loss on revaluation will not be accrued in the income statement (referred to below as IS) but will be shown as a revaluation reserve/provision in the balance sheet (referred to below as BS).
In the following examples, 100 AFM shares were bought cash on 1 Jan, at R1,00 per share. On 31 Jan, the shares are valued at R1,10:
9.3.2 Equities in a trading portfolio or for speculative purposes
Equities kept for any other reason than long-term investment purposes, should be revalued to fair value (often called mark-to-market) for financial statements and the profit or loss on re-valuation accrued in the income statement:
9.4 Accounting for discount instruments (money market and capital market)
Discount instruments such as BAs, treasury bills and zero-rated coupon bonds do not pay interest in their lifetime and fall under this category. Investments can be made in these instruments for the purpose of keeping it to maturity (outside a trading portfolio), as long-term investments (zero coupon bonds) or for trading purposes. Non-trading instruments are normally accounted for at cost and the discount received is amortised over the period. The market value is shown by way of a note to the financial statements.
For the following examples, a 90-day BA with a nominal value of R1 million is bought on 1 Jan. (issue date) for R700 000. At 31 Jan. the market value is R760 000.
9.4.1 Discount instruments kept up to maturity (outside a trading portfolio) or for long-term investment purposes
9.4.2 Discount instruments in a trading portfolio or for speculative purposes
Instruments in a trading portfolio are always shown at market value and the revaluation profit or loss is accrued in the income statement.
9.5 Accounting for interest rate instruments
Instruments with a term to maturity at issue date of 1 year or shorter do not usually pay interim interest payments, but only one interest payment at maturity. Examples of such instruments are NCDs. Instruments with a term to maturity of longer than 1 year normally pay interest in interim payments such as every six months. No matter where the interest payment physically takes place, the interest must be accrued in financial statements.
The scenario below is applicable to the following examples:
An R386 government bond with a nominal value of R1 million is bought on 1 Feb. at a consideration of R800 000. The clean price is R780 000. The coupon rate on the bond is 12% and interest is paid biannually on 30 June and 31 Dec. On 28 Feb. the market rate at which the bond traded was 13% which gave it a clean price market value of R880 000.
9.5.1 Interest rate instrument kept as long-term investment or up to maturity (outside a trading portfolio)
If the instrument is kept as a long-term investment, or to maturity outside a trading portfolio, it is normally shown at cost (nominal value minus discount), and the market value by way of a note to the financial statements.
Month-end statements (assume the straight-line portion of the discount for one month is R30 000)
On 30 June R600 000 interest will have been accrued when the first interest payment will be received. The following entry is then made:
The interest actually shown in the income statement will be R600 000 less the R20 000 difference between the all-in price paid at purchase and the clean price at the date of purchase.
9.5.2 Interest rate instrument kept in a trading portfolio or for speculative purposes
At the first physical payment of interest, the same entry as above will be made and the same amount will be shown in the income statement as interest income.
9.6 Accounting for futures
When deciding how to account for futures, the same questions must be asked:
All futures in trading portfolios will be shown at market value according to the mark-to-market (M-T-M) technique on SAFEX. The resulting profit or loss will be reflected in the income statement and profits or losses from identified hedges can be set off against the profit or loss from the underlying instrument. Where a long position in a future is kept to acquire an asset in a trading portfolio, the futures position will be treated as a trading portfolio future. For a member of SAFEX, the following day's M-T-M cash flow would agree to the previous day's profit or loss.
In the following examples, 10 all gold index futures were bought on 1 Jan. when the market value index was 800. An initial margin of R30 000 was paid. At day-end on 1 Jan. (morning of 2 Jan.) the market value index rose to 820, giving the buyer a cash inflow of R2 000 on 2 Jan.
9.6.1 Futures bought or sold for long-term investment purposes
In this category falls
As futures are marked-to-market daily by means of the settlement process, the exchange-traded futures are always shown at market value. Daily profits and losses on futures positions kept for long-term purposes are recognised only when the underlying asset is bought or sold, realising a profit or loss on the total long-term position.
Because most futures are cash settled, the underlying asset is not necessarily bought or sold at the close-out of the futures contract, especially if the transaction was to hedge an existing long or short position for a period.
When the underlying asset is then bought, the long-term hedge reserve/provision must be capitalised to the cost of the long-term asset until the asset is sold eventually. At the sale of the investment, the profit/loss on the total transaction is recognised.
The market value of the underlying asset must always be given by way of a note to the financial statements.
9.6.2 Futures in a trading portfolio or as speculative transactions
Profits or losses on futures in this category should be recognised in the income statement as they occur.
The profit/loss on a hedge will always be set off against the profit/loss on the underlying instrument/portfolio.
9.7 Accounting for options
Similar to futures, options are either used as hedging instruments, to acquire or sell instruments or for speculative reasons. The question must again be asked whether the option was bought for long-term purposes or for trading/speculative purposes. Call options that were written could hardly be for any other purpose than for speculative gain or speculative hedging. In some instances a case for long-term investment purposes could be made out with written put options, although the outcome of the acquisition of the final investment is uncertain.
Exchange-traded options and warrants are treated similarly to futures and are reflected at market value determined by the exchange. OTC options should be reflected at a fair value using one of the recognised valuation models such as the Black-Sholes model for European options and the binomial model for American options.
The undermentioned facts apply in the examples that follow:
An OTC call option on 1 R153 bond is bought on 1 Jan. at a premium of R3 000.
On 31 Jan. the value of the option was R2 400.
The option is exercised on 2 Feb. and the R153 is bought for R800 000 when the all-in price market value is R808 000 and the clean price is R780 000.
9.7.1 Options traded for long-term investment purposes
9.7.2 Options in a trading portfolio or for speculative purposes
9.8 Accounting for interest rate swaps
Interest rate swaps are mostly used to hedge interest rate flows. In some exceptional cases it might be used to hedge capital value and in these cases the cash flow received from the swap agreement or paid in because of the swap agreement will be treated the same as the capital depreciation or appreciation. This means that
In the case where they are used to hedge interest rate cash flows, profit and losses should be recognised as they occur and be set off against interest paid or received on the underlying loan/investment. If a month-end or a year-end occur between reset dates, a calculation should be made using the current interest rate yield curve.
The following facts are applicable in this example:
Maranatha Ltd. swaps its floating interest rate on a loan of R1 million with a fixed rate for a period of 1 year. Goodso bank is the payer of the floating rate and Maranatha Ltd. the payer of the fixed rate.
The fixed interest rate is 15% and the floating interest rate is the BA rate converted to a yield. The agreement commences on 1 Jan. 19.1 with reset dates every three months and payment dates three months after reset.
On month-end date when the month-end statements are drawn up, the net amounts payable or receivable according to calculations using the yield curve are as follows:
31 Jan. - R416,67 receivable
28 Feb. - R 83,33 payable
On 31 March, the first reset date, the floating rate is 15,3%. The first payment date is 30 June. Net future interest receivable on 31 March for future reset dates according to the calculation using the yield curve is: R166,67.
Accounting entries for these dates are as follows:
Notes to the financial statements should show the nominal amounts of open interest rate swap agreements and their interest rate spreads with the agreed fixed and floating rates of these agreements.
9.9 Accounting for interest rate floors, caps and collars
Similar to interest rate swap agreements, these agreements have reset dates on which payment calculations will take place. As seen from the working of these contracts, payments will not always take place, but only when certain conditions are met.
On month-end the calculations will be done using the current yield curve. If there is an anticipated profit or loss, the profit or loss will be accrued and off-set against the underlying interest cash flow. On reset date, any payment to be made will also be accrued and off-set against the underlying interest cash flow. These entries are similar to the entries for an interest rate swap as shown above.
In the exceptional case of these agreements being used to hedge capital values, the profits and losses from the agreement will be accounted for in the same manner than the accounting treatment of the capital value of the underlying asset/liability.
9.10 Accounting for forward rate agreements
The payment made or received on a forward rate agreement will be accrued on reset date, which is normally the starting date of the loan. This accrual will be recognised and off-set or added to the interest paid on the underlying loan. The amount will be amortised on a day-to-day basis for the term of the loan.
Valuations of FRAs after contract date and before reset date should be done using the current yield curve. Notes to the financial statements should show the nominal amounts of the open FRAs, the floating rate and the fixed rate per agreements.