Your SlideShare is downloading. ×
  • Like
International Financial Reporting Standards: Derivative ...
Upcoming SlideShare
Loading in...5
×

Thanks for flagging this SlideShare!

Oops! An error has occurred.

×

Now you can save presentations on your phone or tablet

Available for both IPhone and Android

Text the download link to your phone

Standard text messaging rates apply

International Financial Reporting Standards: Derivative ...

  • 844 views
Published

 

  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Be the first to comment
    Be the first to like this
No Downloads

Views

Total Views
844
On SlideShare
0
From Embeds
0
Number of Embeds
0

Actions

Shares
Downloads
10
Comments
0
Likes
0

Embeds 0

No embeds

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
    No notes for slide

Transcript

  • 1. Power & Utilities Whitepaper Series Energy & Resources International Financial Reporting Standards: Derivative Accounting Considerations under IAS 32/39 and IFRS 7 for Energy Transacting Activities International Financial Reporting Standards (IFRS) promises to bring a number of significant accounting changes for companies in the Power & Utilities (P&U) industry, not least of which will be changes to accounting for financial instruments and more specifically, derivative contracts. Those familiar with the rules under accounting principles generally accepted in the United States (U.S. GAAP) will no doubt understand the complexities associated with the U.S. accounting rules for derivatives under FASB Statement No. 133, Derivative Instruments and Hedging Activities Contacts (FAS 133), and the particular challenges that this accounting standard has presented for energy IFRS Solutions Center: transacting activities. IFRS has comparable accounting rules included in IAS 32, Financial Instruments: D.J. Gannon Presentation (IAS 32), and IAS 39, Financial Instruments: Recognition and Measurement (IAS 39). National Leadership Partner IFRS Solutions Center Although the overall intent for these two accounting standards is similar to FAS 133, the IFRS Deloitte & Touche LLP guidance approaches derivative instruments from more of a principles-based perspective. Given +1 202 220 2110 the detailed and often complex rules under FAS 133, it should come as no surprise that there are dgannon@deloitte.com differences in interpretation and in application of the IAS 32/39 guidance. This is particularly true Industry Contacts: as it relates to energy transacting activities, in part due to the very specific interpretive guidance For more information, please contact: that U.S. GAAP provides through various Derivative Interpretation Group (DIG) issues. Although Greg Aliff IAS 39 has some interpretive guidance, this guidance is less extensive and is not specific to energy Vice Chairman transacting activities. U.S. Energy & Resources Leader Deloitte LLP IFRS has a comprehensive disclosures standard for financial instruments, IFRS 7, Financial Instruments: +1 703 251 4380 Disclosures (IFRS 7). This standard requires detailed disclosures for derivative instruments, including galiff@deloitte.com their use in an entity’s business, and a number of qualitative and quantitative measures for assessing Bill Graf the significance of derivatives in the business and the relative significance of the various risks Partner associated with those instruments. Companies who are familiar with the U.S. GAAP derivatives Deloitte & Touche LLP +1 312 486 2673 disclosure rules will see some parallels between existing derivatives disclosures under FAS 133 and wgraf@deloitte.com 161, Disclosures about Derivative Instruments and Hedging Activities: an amendment of FASB Andy Hickey Statement No. 133, and fair value measurement disclosures under FAS 107, Disclosures About Fair Partner Value of Financial Instruments, FAS 157, Fair Value Measurements, and the required disclosures Deloitte & Touche LLP under IFRS 7. However, the IFRS requirements are more extensive and include certain items which +1 212 436 5322 companies may previously have included only in the Management’s Discussion & Analysis (MD&A) ahickey@deloitte.com sections of their public filings1. Brian Murrell Partner This paper provides a summary of the relevant IFRS accounting standards and addresses some of the Regulatory & Capital Markets Consulting more common accounting issues facing companies with significant energy transacting activities. Deloitte & Touche LLP +1 212 436 4805 bmurrell@deloitte.com Introduction to the accounting standard Jan Umbaugh The derivative accounting rules under IFRS are included in three different accounting standards. Partner Broadly stated, IAS 39 provides the definition of a derivative and addresses the various scoping Deloitte & Touche LLP +1 561 962 7706 considerations to determine what qualifies for derivative accounting treatment; IAS 32 addresses jumbaugh@deloitte.com the financial statement presentation considerations; and IFRS 7 deals with the required financial statement disclosures.
  • 2. Let’s examine each of these standards in additional detail. IAS 32 establishes the “principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset.” IAS 39 establishes “the principles for recognizing and measuring financial assets, financial liabilities and some contracts to buy or sell nonfinancial items. Requirements for presenting information about financial instruments are in IAS 32, Financial Instruments: Presentation.” IFRS 7 establishes disclosures on financial instruments that enable users to evaluate the significance of financial instruments for the entity’s financial position and performance. It also requires disclosures regarding the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks. Viewed together, these standards address a number of topics2 which are addressed under U.S. GAAP in a number of different accounting standards. How this differs from U.S. GAAP As noted above, while the overall intent of the accounting framework for derivative instruments under IFRS is consistent with the rules provided under U.S. GAAP, there are some key differences which should be considered. Some of the more significant issues that energy companies will face during conversion relate to the differences in the fundamental definitions under the two standards, and differing views on certain scope exemptions. Further, as also previously mentioned, U.S. GAAP presently includes additional interpretive guidance of relevance to energy transacting activities which is not similarly addressed under IFRS. Some of these significant differences are summarized below. “Normal” contracts One of the key scope exemptions for energy companies is what is known under U.S. GAAP as the exemption for contracts which qualify as “normal purchases and normal sales” (NPNS). IAS 39 contains a similar scope exemption for physical delivery contracts of a nonfinancial item for an entity’s “own use” (own use). In both instances, the scope exemption is meant to exclude ordinary physical supply arrangements from derivative accounting treatment. However, the standards also seek to identify contracts which are not used for operational purposes as derivative instruments. In other words, although certain arrangements may involve a physical commodity, the arrangements may be substantively the same as a financial instrument if entities use them for trading purposes rather than for buying and selling the commodity in the normal course of business. There are a few differences between the standards, however, that should be considered. The first difference is the simple ordering of the decision process under IAS 39 as compared to FAS 133. For FAS 133 purposes, the NPNS question is asked only after a contract has previously been determined to be a derivative (more on this later), and only then by special election for qualifying contracts. However, IAS 39 addresses own use prior to the derivative determination, and does not allow an election (that is, if a contract qualifies as own use under IFRS, an entity cannot apply derivative accounting treatment). This difference alone can result in some significant GAAP differences, since companies may find that they have certain positions which would qualify as NPNS under U.S. GAAP, but are not elected as “normal” and are thus treated as derivatives on a fair value basis. However, IAS 39 may require accrual treatment for these same contracts. The IAS 39 own use exemption also focuses on several means of potential net settlement. Although these types of net settlement are similar to net settlement under FAS 133, the IAS 39 definition is broader. Both standards recognize that net settlement may be explicitly stated or implied, or may be possible by delivery of a “readily convertible to cash” asset. FAS 133 also notes that net settlement is possible if there is a market mechanism which facilitates offsetting of contractual rights and obligations. IAS 39 broadens this particular concept, noting that offsetting may happen prior to delivery by entering into offsetting contracts, or effectively happen upon delivery, if the delivered asset is resold for a trading purpose. Further under U.S. GAAP, many written option and forward contracts for delivery of electricity are provided a special exception to the unplanned netting rules in FAS 133, under Derivatives Implementation Group Issue No. C15, Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type Contracts and Forward Contracts in Electricity. As a consequence, companies may find that fewer contracts qualify as own use transactions under IFRS.
  • 3. Definition of a derivative Both IAS 39 and FAS 133 include definitions of a derivative based on a number of criteria, including the extent to which a transaction may contain an underlying price that would be used to value the arrangement in the market and whether any initial investment was required at contract inception (with a significant initial investment potentially indicating that an arrangement is not a derivative, but instead is potentially a financing arrangement). However, there are a few key differences in the definitions under these standards which collectively mean that the definition of a derivative is broader under IAS 39. The first key difference is that U.S. GAAP requires a contract to contain either a notional quantity or other payment provision, in addition to the requirement that the contract contain an underlying. From an energy contract perspective, this generally results in significant attention being paid to stated quantities in an arrangement, or in absence of clearly stated quantities, other considerations around potential default provisions, contract appendices, or historical usage patterns that may be considered legally enforceable in an event of default. Under FAS 133, if a notional does not exist, then the contract is not a derivative. IAS 39 does not include a notional requirement, so it is likely that more contracts will therefore qualify as derivatives under IFRS. A second key difference is that FAS 133 includes a net settlement requirement in the derivative definition. In the context of this definition, net settlement would include any ability, explicit or implicit, to settle an arrangement net, the existence of an outside market mechanism which would facilitate net settlement by fully offsetting rights and obligations under the original agreement, or delivery of a “readily convertible to cash” asset (which is an implicit ability to net settle, but which can be overcome via the NPNS election as discussed above). By contrast, IAS 39 simply calls for settlement at a future date and only addresses net settlement in the context of the own use exemption3 as discussed above. Embedded derivatives Both accounting standards address the concept of embedded derivatives, which are terms within a non-derivative contract that may individually be viewed as a separable derivative component. Both standards also provide considerations to determine instances when an embedded derivative requires separate accounting, or may instead be considered “clearly and closely related” to the host contract and simply accounted for alongside that host arrangement (i.e., the embedded derivative is not separated from the host contract). There are a few differences worth mentioning, however. One issue is the “grandfathering” provisions in FAS 133 which did not require a review of contracts existing before a particular date to search for potential embedded derivatives (generally January 1, 1999, for most companies). However, IFRS does not contain this similar grandfathering provision so there may be long-term legacy contracts that contain embedded derivatives that need to be assessed from an IAS 39 perspective. A second issue is the potential implications of pricing terms that are not closely related to the asset to be delivered, and the interrelationship with the “normal” or own use determination discussed above. Under IFRS, if the pricing terms are not closely related to the asset being sold or purchased, such terms do not preclude own use treatment for the host contract. However, the pricing terms may require separation as an embedded derivative. Under U.S. GAAP, if the pricing terms in a purchase, sale, or service contract are not clearly and closely related to the asset being sold or purchased, the application of the normal purchases and normal sales exemption is precluded and thus the entire contract may have to be accounted for as a derivative. Another difference is the treatment of multiple embedded derivatives within an arrangement. Under IAS 39, if a contract contains multiple embedded derivatives requiring bifurcation, an entity should account for those features separately if they relate to different risk exposures and are “readily separable and independent of each other.” However, FAS 133 requires multiple features embedded in a single contract to be bifurcated as if they were a single compound embedded feature, regardless of interdependencies between those features. In terms of reassessing whether embedded derivative terms require separation, IFRS only allows reassessment if there is a change in the terms of the contract that significantly modifies the cash flows that would be required under the contract (see IFRIC Interpretation 9, Reassessment of Embedded Derivatives). U.S. GAAP requires entities to reevaluate embeddeds for possible bifurcation at least quarterly or whenever the company prepares financial statements for an external party (e.g., filing financial statements with an exchange, providing financial statements to a bank for debt covenant purposes).
  • 4. Hedge accounting Although there are significant differences in the hedge accounting guidance under IFRS and U.S. GAAP, only a few differences are relevant for energy transacting activities. Some of these differences are considered below. U.S. GAAP specifically defines the following risk components that may be hedged (overall fair value or cash flows, interest rate risk, foreign currency risk, credit risk, etc.). IFRS provides greater flexibility in defining the particular risk being hedged, which is restricted only by the entity’s ability to measure effectiveness. One such difference is the guidance under U.S. GAAP DIG Issue G20, Cash Flow Hedges: Assessing and Measuring the Effectiveness of a Purchased Option Used in a Cash Flow Hedge, which allows companies to exclude an option’s time value from the assessment of hedge effectiveness without requiring that time value to be immediately included in income. By comparison, IAS 39 permits companies to exclude option time value from the assessment, but then requires changes in the excluded time value to be recognized in current period earnings (although not identified as hedge ineffectiveness). Another potential difference relates to the timing of an entity’s assessment of hedge effectiveness. IAS 39 requires an entity to assess a hedging relationship’s effectiveness at least whenever it prepares its annual or interim financial statements, although there is no IFRS requirement to prepare interim financial statements. FAS 133 requires assessment of hedge effectiveness every time financial statements are issued, and at least every three months. Consequently, there may be differences in the timing of these assessments for companies that are not required to file quarterly financial statements. The use of written options may potentially create another difference. Because a written option provides a significantly greater potential for loss than gain, IAS 39 does not allow a written option to be designated as a hedging instrument “unless it is designated as an offset to a purchased option, including one that is embedded in another financial instrument.” IAS 39, Implementation Guidance F.1.3, provides guidance on determining whether a combination of options is a written option. In comparison, FAS 133 is a little more lenient in permitting a written option to be designated as a hedging instrument. Specifically, it permits an entity to designate a written option as a hedging instrument as long as “the combination of the hedged item and the written option provides at least as much potential for gains as a result of a favorable change in the fair value of the combined instruments [favorable cash flows] as exposure to losses from an unfavorable change in their combined fair value [unfavorable cash flows].” IAS 39 also places some restrictions on partial term hedging that are not included under FAS 133. In particular, IAS 39 does not permit an entity to designate a hedging relationship “for only a portion of the time period during which a hedging instrument remains outstanding.” In other words, if the hedging instrument has a longer term than the designated hedging relationship, the relationship does not qualify for hedge accounting (note, however, that this does not preclude an entity from initially designating a hedging relationship for the term of the hedging instrument, then later dedesignating the hedging relationship before the maturity of the hedging instrument). Financial instrument disclosures Both IFRS and U.S. GAAP require numerous disclosures around an entity’s use of financial instruments and derivative contracts, including the reasons for their use, the significance of those positions to the business, and their associated risks. U.S. GAAP disclosure requirements are included in a number of accounting standards, including derivative instrument disclosures in FAS 133 and FAS 161, and fair value measurement disclosure requirements explained in FAS 107 and FAS 157. The disclosure requirements included in IFRS 74 address the disclosure of derivative instruments, the significance of those instruments for an entity’s financial position and performance, and qualitative and quantitative information about exposure to risk arising from these instruments. The IFRS 7 requirements are more extensive than U.S. GAAP and additionally require certain items such as sensitivity analyses to be included in the financial statement footnotes, as compared to certain items which are only required for public U.S. GAAP filers in MD&A. By moving these additional disclosures to the financial statement footnotes, they are now subject to external audit, and consequently also subject to additional requirements under internal controls over financial reporting. IFRS 7 also requires that quantitative disclosures about the extent to which the entity is exposed to risk be based on information provided internally to the entity’s key management personnel.
  • 5. What these differences mean for energy companies Derivatives accounting can be a challenging area for many energy companies, since the scope under both IFRS and U.S. GAAP broadly impacts a number of physical commodity contracts. Since energy companies are additionally exposed to significant commodity and other market-based risks, entities may also be impacted to the extent that they take reasonable steps to economically protect against these risks through financial markets. Given the derivative accounting implications, the differences between IAS 39 and FAS 133 addressed in the preceding section may also have significant implications on energy companies’ financial statements (and potentially significant impacts on individual entities’ transacting behaviors as they potentially modify their accounting elections and possibly even specific transacting strategies in response to changes in accounting treatments). Consequently, a thorough analysis may be warranted in order to assess the derivative accounting challenges presented by converting to IFRS. Changes in accounting policies and procedures The most obvious changes that will be required may be the need to refresh existing accounting policies and procedures and modify them to address the specifics of the IFRS accounting standards. Companies presently following U.S. GAAP may be able to leverage existing documentation, but the differences described above will necessitate some important modifications. In particular, given the differences previously described around own use positions and the IAS 39 definition of a derivative, entities will want to clearly state their policies around their energy transacting activities, and potentially further address the types of contracts used, how those positions are utilized, and how the underlying volumes align with the ongoing operational needs of the business. In integrated energy transacting shops, companies may also need to make further distinctions between physical, operational activities, and those activities that are more speculative in nature. Changes in internal controls and related documentation There will likely also be certain challenges in relation to internal controls, including controls design related to the identification of all derivative positions and appropriate data capture to ensure appropriate subsequent valuation and financial statement reporting. For instance, since the population of “derivatives” will likely differ under the two different GAAPs, the contract assessment process will also need to be changed to identify the new IAS 39 derivative population. Internal controls may require some level of redesign or expansion to ensure that this process is appropriately handled. Systems issues Information systems present some unique challenges, such as potential modifications to separately capture and track all IAS 39 derivatives, and to handle different contract valuations as a result of different scoping considerations. For instance, some contracts not considered derivatives under FAS 133 may now be in scope under IAS 39, and thus would need to be properly identified within any deal capture and valuation system. Additionally, transactions which qualify as derivatives under FAS 133 may be considered own use for IFRS purposes, but contain an embedded derivative component which requires separate valuation. In these cases, systems would need to be modified to only value and report the embedded derivative and to separately account for the host contract under the applicable accounting guidance. If the systems are unable to handle the changes at this level of complexity, companies may need to rely on non-system-based solutions and work-arounds, which will increase compliance costs and time involved as a result of this lack of automation, and additionally may present other internal control risks which will need to be managed. Human resource considerations Companies additionally need to consider the demands that the shift to IFRS will place on their personnel. Human resource challenges will be diverse, including such issues as simply balancing staff headcount with the required tasks involved in the initial conversion process and ongoing monitoring and compliance. Companies will also face challenges as it relates to staff training and development, since most U.S.-based accounting resources presently have very little prior knowledge of IFRS, or experience working with it in practice. Consequently, companies will need to tailor appropriate training programs, based upon the specific needs of their people and their individual task responsibilities, and then roll out those training programs at appropriate times. For instance, people who will be deeply involved in a conversion exercise will need a more detailed level of training much sooner than others who will only be involved peripherally in the conversion effort, or who will only be engaged later on in sustaining IFRS reporting post-conversion.
  • 6. Prior lessons learned in the conversion process Companies facing conversion have the advantage of learning from the experiences of others who have already been through the process, including all listed companies in the European Union (EU) who were required to convert to IFRS in 2005. Based on the experiences of these companies, a number of common themes have emerged. One lesson has been that the transition from a rules-based way of thinking to a focus on principles has been more challenging than anticipated. This may prove to be particularly true for U.S.-based companies, since accountants trained in U.S. GAAP are accustomed to researching specific accounting rules and regulations to find an accounting answer. Under IFRS, practitioners will need to focus more on the principles involved, and particularly as it relates to derivatives, focus on the underlying business intent and actual business usage of individual contracts rather than comparing particular legal terms and conditions against specific U.S. GAAP paragraphs or DIG issues. Another lesson learned is that derivatives accounting is sufficiently complicated and time-consuming as to warrant its own separate conversion workstream. In many cases, EU-based companies established separate conversion teams specifically dedicated to derivatives. A final observation is that the overall IFRS conversion process takes longer than anticipated, and the same is true for addressing the derivatives accounting considerations more specifically. Many companies underestimated the required resource and time commitments and consequently had to rush to finalize their conversion processes on time. Closing thoughts Accounting for derivative instruments can be a vexing proposition. Certainly the accounting literature is complicated enough, but converting from one set of complicated rules to another, with significant (and sometimes subtle) differences to address, presents numerous challenges. Given all of the challenges involved in terms of technical accounting differences, required policy, procedure, and technology changes, and even the human resource issues involved, there are clear advantages to properly planning the conversion process across appropriate timelines to ensure that the conversion objectives can be met. Think through your conversion process, and spend the time early on to fully consider the possible accounting consequences and what those changes will mean across your business and across various disciplines. Consider also the resource requirements and what that may suggest in terms of particular resource or timing constraints, so that those issues are also addressed in the conversion plan. Finally, once the plan is in place, start the conversion process early so you can work through the process at a reasonable and measured pace. The process will not be easy, but proper planning and efficient execution will increase the likelihood that your conversion will be successful. Endnotes 1 Note also that the IASB has issued an exposure draft which, if adopted, would conform the IFRS fair value measurement disclosures to those as required under FAS 157. 2 These standards additionally include guidance on other financial instrument-focused topics, such as determining whether an item should be included as a liability or as an equity instrument, which are not within the scope of this paper. 3 Note that the IAS 39 version of net settlement as described in connection with the own use exemption is also broader than the FAS 133 definition of net settlement. In particular, where U.S. GAAP focuses on the potential existence of a market mechanism facilitating net settlement, IFRS focuses on an entity’s ability and practice of settling net prior to delivery, or practice of taking physical delivery but then reselling the delivered volumes for a profit motive. While similar concepts are addressed under U.S. GAAP in relation to the NPNS exemption, those issues may not be addressed in certain circumstances where a contract is disqualified from derivative accounting under the FAS 133 definition of a derivative despite certain transacting activities that would place the contract in scope under IAS 39. 4 Refer to Footnote 1.
  • 7. Resources Deloitte has extensive IFRS experience in the P&U industry. With thousands of IFRS-experienced professionals in our global network, we provide a comprehensive array of services related to IFRS. As a multidisciplinary organization, we can help companies address a wide range of IFRS issues. Deloitte offers companies assistance with: • Evaluating the potential impacts of IFRS • Assessing readiness for IFRS conversions • Implementing IFRS conversions, providing support with technical research, project management, and training • Addressing the implications of IFRS in such areas as tax, finance operations, technology, and valuation Deloitte’s U.S. Energy & Resources group: We proudly serve power and utilities clients, helping them address their most critical challenges in order to deliver value for their shareholders and execute initiatives designed to further their strategic objectives. Overview of our Power & Utilities group: • Audits half of the Fortune 1000 utilities and energy companies • Provides accounting and enterprise risk services to 79% of the Fortune 500 utilities and energy companies • Provides consulting services to the entire top 10 utilities and energy companies in the Fortune 1000 • Provides financial advisory services to 9 out of 10 utilities and energy companies in the Fortune 1000 • Provides tax services to the entire top 10 utilities and energy companies in the Fortune 1000 • More than 1,500 U.S. practitioners serving the industry, including over 350 Partners, Principals and Directors Power & Utilities Industry Involvement: Our practitioners understand that leadership demands active participation across the industry’s diverse community. We actively participate in the following organizations: • American Gas Association • Edison Electric Institute • Electric Power Supply Association • United States Energy Association Thought leadership: • 2008 Deloitte Electric Consumer Survey • 2008 Deloitte Utility Commissioners Survey • 2008 Deloitte Energy Conference Summary Report • The Risk Intelligent Enterprise: ERM for the Energy Industry Technical Publications: • Power & Utilities Accounting, Financial Reporting and Tax Update • Energy Quarterly Brief Deloitte’s Online Resources: For a wealth of online resources related to IFRS, visit www.deloitte.com/us/ifrs. Available materials include newsletters, whitepapers, pocket guides, timelines, webcasts, podcasts, and more. International Accounting Resources: The International Accounting Standards Board (IASB) develops international financial reporting standards for general purpose financial statements. Visit the IFRS section of www.iasb.org for additional details and copies of the standards. As used in this document, “Deloitte” means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Member of Copyright © 2008 Deloitte Development LLC. All rights reserved. Deloitte Touche Tohmatsu