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FRS 102 Implementation Basic Instrument Classification: Fixed Rate Bank Loans

1. Introduction

FRS102 has introduced several changes to the accounting of financial instruments relative to UK GAAP, one of them being the division of financial instruments in two camps: “Basic” and “Other”. This note focusses on a particular point relating to debt instruments, where Basic instruments are measured on an ongoing basis at amortised cost with Other ones measured at fair value.

There are a number of elements of the drafting of FRS102 which have led finance teams and auditors to scratch their heads slightly and where accepted custom and practice have not yet emerged. One specific point, noteworthy mainly because of the scale of the potential impact, is the treatment of fixed-rate bank loans (embedded hedges).

Fixed rate bank loans typically include “two way break clauses”, and these have been interpreted by some as a failure to meet one of the set conditions necessary to be treated as Basic.

2. The problem

There are several characteristics required for Basic status. The one triggering these discussions is the requirement that:

“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.” (FRS102 11.9 (b)).

Most bank loans which allow a borrower to fix the rates, but otherwise prepay without penalty, contain a clause that states if a fixed rate loan is terminated early and the fixing MTM is in the borrower’s favour, the amount payable to the lender is the loan amount, plus accrued interest, less any gain associated with the fixing. This is a quid pro quo for the bank requiring to be compensated if the fix if broken and the MTM is in the lender’s favour – the MTM will in that instance need to be paid to the bank on top of the principal plus interest. So if rates have (broadly, for a vanilla fixed rate) fallen, the MTM will be in the bank’s favour and they will need to be paid that as well as principal + interest, whereas if rates have risen the borrower will be able to net off the MTM in their favour.

This is of course a slight paraphrase and there are transaction costs to consider as well as a discounting methodologies which are not particularly borrower-friendly. But that is the broad principle. The terms of these provisions do vary and are sometimes quite heavily negotiated, but the principle is fairly standard.

The commercial context is that the banks require to be made whole if they lose out from an early termination of a fix (i.e. having potentially hedged their own position with a market counterparty, or within their overall treasury position etc.). Hence the description as a “two-way break cost”.

3. Interpretation

Some auditors have taken the view, that because the lender could potentially be repaid less than principal plus accrued interest, the criterion quoted above is not met. It is not hard to see why this interpretation is at least superficially reasonable.

However, our view is that the wording of that clause in FRS102 sets the stage fairly clearly for treating a settlement of MTM, which of course relates to future interest payments rather than past ones, as not being seen in this way. Based on a commercial understanding of the reasons for these clauses – risk management rather than an indication of an intention to “trade” rates positions – it seems entirely reasonable to treat vanilla embedded fixed rate loans as Basic.

But equally the reality is that these are new standards. It is important that users and auditors are comfortable with interpretation but the words on the page are now set, at least for now, and a pure accounting analysis can get quite in depth. Without going into all the detail, there are other phrases in the section which have been used to support one side or the other in this debate.

There is no doubt, it seems to us, that applying fair value to all embedded fixed rates would have significant consequences for the usefulness of accounts, and generally seems counter to the general thrust of the FRS102 approach of moving to a simplified set of rules. There is often, for example, a significant difference between fair value of the hedge (probably the MTM) and the fair value of the overall position and the application of embedding fixes in previously floating-rate loans, and vice versa, would need to be considered carefully; this sort of ambiguity is clearly unhelpful to the users of accounts. The application to capital markets instruments which can potentially be acquired on market at below par and redeemed perhaps raises similar issues. But this isn’t the debate, these practical issues are not it seems in doubt by others either.

To be clear, the impact is potentially very significant: if the MTM is say 20% of the loan face value and loans with embedded fixes represent 50% of a borrower’s loan portfolio, then treating all of these loans as ”Other” could increase reported indebtedness by 10%. The impact on financial covenants with sensible change-in-GAAP provisions can be contained – it just becomes another moving part in the FRS102 adaptation – but there may be other covenants to consider if the impact on reserves is significant and there is also the impact on creditor perceptions going forward.

There are other elements of FRS102 section 11 which are perhaps more open to interpretation than might have been intended (in our view), so we expect some settling in of the standards and potentially this issue falls into that category but at this stage this is not clear.

4. Next Steps

Given that FRS102 allows a user to “trade up” to IFRS9 for recognition and measurement of financial instruments, this may be an option worth exploring as IFRS9 would not require these loans to be measured at fair value. However, at present the debate is ongoing and may result in those auditors taking perhaps a more cautious literal interpretation of the wording concluding after all that a more commercial interpretation leads towards a “Basic” classification.

Centrus is closely involved in discussions around this issue and at this stage we’re advising clients to keep a watching brief. Potential specific preparatory actions might include either thinking through IFRS9 implications or confirming “change in GAAP” clauses in relevant loan agreements (including “no loss” and any other relevant clauses as well as financial covenants, where relevant) where this hasn’t already been done as part of wider FRS102 work.

Centrus does not provide formal accounting advice, but our view is that there is a strong case that ‘regular’ loans with embedded fixes should be classified as ‘Basic’ instruments.

27th May 2016