Tag: Balance Sheet

Derivatives Accounting

A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. There are two key concepts in the accounting for derivatives. The first is that ongoing changes in the fair value of derivatives not used in hedging arrangements are generally recognized in earnings at once. The second is that ongoing changes in the fair value of derivatives and the hedged items with which they are paired may be parked in other comprehensive income for a period of time, thereby removing them from the basic earnings reported by a business.

The essential accounting for a derivative instrument is outlined in the following bullet points:

• Initial recognition. When it is first acquired, recognize a derivative instrument in the balance sheet as an asset or liability at its fair value.
• Subsequent recognition (hedging relationship). Recognize all subsequent changes in the fair value of the derivative (known as marked to market). If the instrument has been paired with a hedged item, then recognize these fair value changes in other comprehensive income.
• Subsequent recognition (ineffective portion). Recognize all subsequent changes in the fair value of the derivative. If the instrument has been paired with a hedged item but the hedge is not effective, then recognize these fair value changes in earnings.
• Subsequent recognition (speculation). Recognize in earnings all subsequent changes in the fair value of the derivative. Speculative activities imply that a derivative has not been paired with a hedged item.

The following additional rules apply to the accounting for derivative instruments when specific types of investments are being hedged:

• Trading securities. This can be either a debt or equity security, for which there is an intent to sell in the short term for a profit. When this investment is being hedged, recognize any changes in the fair value of the paired forward contract or purchased option in earnings.
• Held-to-maturity investments. This is a debt instrument for which there is a commitment to hold the investment until its maturity date. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value.
• Available-for-sale securities. This can be either a debt or equity security that does not fall into the held-to-maturity or trading classifications. When such an investment is being hedged, there may be a change in the fair value of the paired forward contract or purchased option. If so, only recognize a loss in earnings when there is an other-than-temporary decline in the hedging instrument’s fair value. If the change is temporary, record it in other comprehensive income.

Rules for Accounting Derivatives

Accounting of derivatives is based upon the purpose for which it is used as it can be used for speculation, i.e. to earn profit from derivatives transactions and hedging, i.e. to control the risk of future contracts. Suppose there is speculation loss that is to be recognized immediately in the accounts.

Some of the rules for Accounting of derivatives are as under:

• Initially, derivatives are to be recorded at fair value.
• Re-measurement of fair value is to be done at the end of the financial year or at the end of the contract period, whichever falls earlier.
• The purpose of the derivative is to be determined at the time of entering so as to decide whether it is speculation or hedging.
• Any transaction cost for entering into derivatives is to be charged to the profit and loss account immediately.
• If the derivative is of speculation in nature, the loss or profit is to be immediately recognized in the profit and loss account.
• If the derivative is non-speculative, the loss or gain is to be transferred to a comprehensive income account.
• Journal entries of accounting for derivatives are:

Hedge Accounting

Hedge accounting is an accountancy practice, the aim of which is to provide an offset to the mark-to-market movement of the derivative in the profit and loss account. There are two types of hedge recognized. For a fair value hedge, the offset is achieved either by marking-to-market an asset or a liability which offsets the P&L movement of the derivative. For a cash flow hedge, some of the derivative volatility is placed into a separate component of the entity’s equity called the cash flow hedge reserve. Where a hedge relationship is effective (meets the 80%–125% rule), most of the mark-to-market derivative volatility will be offset in the profit and loss account. Hedge accounting entails much compliance involving documenting the hedge relationship and both prospectively and retrospectively proving that the hedge relationship is effective.

Under IAS 39, derivatives must be recorded on a mark-to-market basis. Thus, if a profit is taken on a derivative one day, the profit must be recorded when the profit is taken. The same holds if there is a loss on the derivative.

If that derivative is used as a hedging tool, the same treatment is required under IAS 39. However, this could bring plenty of volatility in profits and losses on, at times, a daily basis. Yet, hedge accounting under IAS 39 can help decrease the hedging tool’s volatility. However, the treatment of hedge accounting for hedging tools under IAS 39 is exclusive to derivative instruments.

A specific type of hedging transaction that entities can engage in aims to manage foreign currency exposure. These hedges are undertaken for the economic aim of reducing potential loss from fluctuations in foreign exchange rates. However, not all hedges are designated for special accounting treatment. Accounting standards enable hedge accounting for three different designated forex hedges:

• A cash flow hedge may be designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.
• A fair value hedge may be designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.
• A net investment hedge may be designated for the net investment in a foreign operation.

There are three main asset categories that companies use hedge accounting for:

Foreign currency exposures: For transaction exposures, such as forecasted purchases, revenues and expenses in foreign currencies, as well as foreign-currency-denominated assets and liabilities.

Interest rate exposures: Such as forecasted fixed-rate borrowing, variable-rate assets and liabilities, as well as fixed-rate assets and debt.

Commodity exposures: These include forecasted purchases, sales and inventory.

Accounting standards enable hedge accounting for three different designated categories:

Cash flow hedge: Designated for a highly probable forecasted transaction, a firm commitment (not recorded on the balance sheet), foreign currency cash flows of a recognised asset or liability, or a forecasted intercompany transaction.

Fair value hedge: Designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.

Net investment hedge: Designated for the net investment in a foreign operation.

Impairment

In accounting, the decrease in the net asset value of an asset due to the carrying amount of the asset exceeding the recoverable amount thereof. The effect of impairment constitutes the decrease in asset values per the Statement of Financial Position and a corresponding amount recognised through profit or loss in respect of the impairment loss.

Impairment describes a permanent reduction in the value of a company’s asset, typically a fixed asset or an intangible asset. When testing an asset for impairment, the total profit, cash flow, or other benefit expected to be generated by that specific asset is periodically compared with its current book value. If it is determined that the book value of the asset exceeds the future cash flow or benefit of the asset, the difference between the two is written off and the value of the asset declines on the company’s balance sheet.

Impairment is commonly used to describe a drastic reduction in the recoverable amount of a fixed asset. Impairment may occur when there is a change in legal or economic circumstances surrounding a company or a casualty loss from unforeseen devastation.

Factors could lead to the value of the asset declining:

Change in legal climate: It’s also possible that a lawsuit, court case, or some other change to the general business/legal climate could cause a reduction in value of the asset. For example, if a worker gets injured while using your equipment and sues your company, you may not be able to use the asset until the legal situation is resolved.

Market downturn: If the market takes a dip, then the fair market value of an asset may end up being less than its book value. For example, if the real estate market experiences a downturn, then any land or property that you’re holding as an asset could decline in value.

Escalating costs: You may experience a situation where the running costs to maintain an asset are more than you were expecting when you made the initial investment, or the running costs have simply escalated over time, leading to a reduction in overall value.

Impairment vs. Depreciation and Amortization

Impairment of assets may sound similar to the accounting processes of depreciation and amortization (a reduction in the value of an asset over the course of its useful life). While there are some relatively clear similarities between the two concepts, there’s one key distinction: impairment denotes a sudden, irreversible drop in value, whereas depreciation/amortisation reduces the value of the asset over its entire lifetime. So, whereas impairment accounts for unusual drops in an asset’s value, depreciation and amortisation is generally used for standard wear and tear.

Fixed assets, such as machinery and equipment, depreciate in value over time. The amount of depreciation taken each accounting period is based on a predetermined schedule using either straight line or one of multiple accelerated depreciation methods. Depreciation schedules allow for a set distribution of the reduction of an asset’s value over its entire lifetime. Unlike impairment, which accounts for an unusual and drastic drop in the fair value of an asset, depreciation is used to account for typical wear and tear on fixed assets over time.

Asset Retirement Obligation

An Asset Retirement Obligation (ARO) is a legal obligation associated with the retirement of a tangible long-lived asset in which the timing or method of settlement may be conditional on a future event, the occurrence of which may not be within the control of the entity burdened by the obligation. In the United States, ARO accounting is specified by Statement of Financial Accounting Standards (SFAS, or FAS) 143, which is Topic 410-20 in the Accounting Standards Codification published by the Financial Accounting Standards Board. Entities covered by International Financial Reporting Standards (IFRS) apply a standard called IAS 37 to AROs, where the AROs are called “provisions”. ARO accounting is particularly significant for remediation work needed to restore a property, such as decontaminating a nuclear power plant site, removing underground fuel storage tanks, cleanup around an oil well, or removal of improvements to a site. It does not apply to unplanned cleanup costs, such as costs incurred as a result of an accident.

Firms must recognize the ARO liability in the period in which it was incurred, such as at the time of acquisition or construction. The liability equals the present value of the expected cost of retirement/remediation. An asset equal to the initial liability is added to the balance sheet, and depreciated over the life of the asset. The result is an increase in both assets and liabilities, while the total expected cost is recognized over time, with the accrual steadily increasing on a compounded basis.

An asset retirement obligation (ARO) is a legal obligation that is associated with the retirement of a tangible, long-term asset. It is generally applicable when a company is responsible for removing equipment or cleaning up hazardous materials at some agreed-upon future date.

The purpose of asset retirement obligations is to act as a fair value of a legal obligation that a company undertook when it installed infrastructure assets that must be dismantled in the future (along with remediation efforts to restore their original state). The fair value of the ARO must be recognized immediately, so the present financial position of the company is not distorted; however, it must be done reliably.

AROs ensure that known future problems are planned for and resolved. In the real world, they are utilized mainly by companies that typically use infrastructure in their operations. A good example is oil and gas companies.

Calculating AROs

When a company installs a long-term asset with future intentions of removing it, it incurs an ARO. To recognize the obligation’s fair value, CPAs use a variety of methods; however, the most common is to use the expected present value technique. To use the expected present value  technique, you will need the following:

• Discount Rate

Acquire a credit-adjusted, risk-free rate to discount the cash flows to their present value. The credit rating of a business may affect the discount rate.

• Probability Distribution

When calculating the expected values, we need to know the probability of certain events occurring. For example, if there are only two possible outcomes, then you can assume that each outcome comes with a 50% probability of happening. It is recommended you use the probability distribution method unless other information must be considered.

To calculate the expected present value of an ARO, companies should observe the following iterative steps:

• Estimate the timing and cash flows of retirement activities.
• Calculate the credit-adjusted risk-free rate.
• Note any increase in the carrying amount of the ARO liability as an accretion expense by multiplying the beginning liability by the credit-adjusted risk-free rate for when the liability was first measured.
• Note whether liability revisions are trending upward, then discount them at the current credit-adjusted risk-free rate.
• Note whether liability revisions are trending downward, then discount the reduction at the rate used for the initial recognition of the related liability year.

IFRS 15 specifies how and when an IFRS reporter will recognise revenue as well as requiring such entities to provide users of financial statements with more informative, relevant disclosures. The standard provides a single, principles based five-step model to be applied to all contracts with customers.

IFRS 15 was issued in May 2014 and applies to an annual reporting period beginning on or after 1 January 2018. On 12 April 2016, clarifying amendments were issued that have the same effective date as the standard itself.

Contracts with customers will be presented in an entity’s statement of financial position as a contract liability, a contract asset, or a receivable, depending on the relationship between the entity’s performance and the customer’s payment.

A contract liability is presented in the statement of financial position where a customer has paid an amount of consideration prior to the entity performing by transferring the related good or service to the customer.

Where the entity has performed by transferring a good or service to the customer and the customer has not yet paid the related consideration, a contract asset or a receivable is presented in the statement of financial position, depending on the nature of the entity’s right to consideration. A contract asset is recognised when the entity’s right to consideration is conditional on something other than the passage of time, for example future performance of the entity. A receivable is recognised when the entity’s right to consideration is unconditional except for the passage of time.

Contract assets and receivables shall be accounted for in accordance with IFRS. Any impairment relating to contracts with customers should be measured, presented and disclosed in accordance with IFRS 9. Any difference between the initial recognition of a receivable and the corresponding amount of revenue recognised should also be presented as an expense, for example, an impairment loss.

Disclosures

The disclosure objective stated in IFRS 15 is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Therefore, an entity should disclose qualitative and quantitative information about all of the following:

• Its contracts with customers;
• The significant judgments, and changes in the judgments, made in applying the guidance to those contracts;
• Any assets recognised from the costs to obtain or fulfil a contract with a customer.

Entities will need to consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the requirements. An entity should aggregate or disaggregate disclosures to ensure that useful information is not obscured.

In order to achieve the disclosure objective stated above, the Standard introduces a number of new disclosure requirements.