TUTORIAL 3: FINANCIAL INSTRUMENTS
PART A: Financial reporting issues, request for advice by Sara Reese – Head of
Financial Control Department
Issue 1
On 1 July 2019, GoBank purchased a portfolio of non-performing loans. On 1
November 2019, these loans, with a carrying amount of £380 million, were transferred
into a separate legal entity, Canwell Loans Ltd (CLL), which is controlled by GoBank.
The carrying amount of each loan is approximately equal to its fair value.
CLL paid £342 million to GoBank in consideration for the transferred loans. CLL issued
debt to the market to raise the required funds. Under the terms of the agreement
between GoBank and CLL, if any of the transferred loans default, GoBank must
compensate CLL for amounts lost, up to a maximum of £250 million.
Sara needs advice on whether GoBank should derecognise the loans. She also needs
to know, if they remain on GoBank’s statement of financial position, whether GoBank
should recognise any impairment allowance against these loans.
Issue 2
GoBank undertakes proprietary trading in exchange-traded derivatives, cleared
through central clearing houses (CCH).
GoBank provides collateral (margin) to the CCH to mitigate credit risk. Initial margin is
provided in the form of 2-year US Treasury bills. The US Treasury bills are
derecognised on the trade date.
A 6% haircut is applied to the initial margin because of its relatively long maturity and
the mismatch of currency exposure. The haircut reduces the value of the asset when
it is used as collateral. The majority of GoBank’s positions are in British pounds.
Subsequent variation margins are provided in British pounds in cash.
Sara needs advice on whether the US Treasury bills should be derecognised and
whether the 6% haircut should be recognised in GoBank’s financial statements. She
is also uncertain how to recognise and disclose the cash provided as variation margin.
Issue 3
GoBank lends to companies by investing in unquoted bonds. GoBank holds these
bonds in a portfolio that meets its objectives by collecting interest and realising capital
gains. These bonds are therefore measured at fair value through other comprehensive
income.
The fair value of each unquoted bond is based on IFRS 13 level 2 inputs, which include
the market interest rates of quoted bonds with similar maturities issued by companies
in the same industry. The interest rates are used to discount each bond’s future cash
flows.
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Widening credit spreads have been noticed for the quoted bonds that are used as an
input to the fair value model applied to GoBank’s bond holdings. Sara would like advice
on whether to adjust the method of fair valuation.
Issue 4
GoBank offers a premium current account for which customers are charged annual
fees paid in advance. The premium account offers an agreed overdraft facility and
holiday insurance.
Customers who choose the premium account pay fees in advance for the following 12
months. During the period from 1 January 2019 to 30 November 2019, £180 million of
premium account fees were received by GoBank.
By 31 December 2019, the average unexpired length of time for advance fee
payments is expected to be 8 months. Sara has recognised £180 million of fees to
date in profit or loss for the year ending 31 December 2019.
Sara would like advice on how to recognise fee income for the year ending 31
December 2019.
PART B: Financial reporting issues, prepared by a junior member of the audit
team of MyBank
Issue 1
On 1 December 2018, MyBank purchased mortgage loans from Kurt Bank plc for £450
million, at par value. The acquired mortgages have a prepayment option that allows
borrowers to repay their loan before maturity. The amount repaid would reflect the
unpaid amounts of principal and interest on the principal amount outstanding at the
time of prepayment. An additional payment is required to compensate the lender for
early termination of the loan.
Interest is charged on the loans at rates that reflect the central bank interest rate and
the credit risk of the borrower. MyBank purchased the loans with the intention of
holding them to collect contractual cash flows.
MyBank is measuring the mortgage loans in its financial statements at amortised cost.
I am not sure that this is the correct treatment.
Issue 2
For several years, MyBank has originated mortgages with interest rates of 2% pa fixed
for 20 years. At the end of the 20-year period, the mortgage may be extended for a
further 10 years at a variable interest rate. If the customer requests an extension,
further fees of £3,000 per loan are payable. At the end of the 20-year period, MyBank
changes the effective interest rate from 2% pa fixed to the central bank base rate plus
5% pa.
MyBank does not recognise a modification gain or loss when an extension is
approved, but I think it should.
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Issue 3
Listed equities acquired for the purpose of short-term trading are measured at fair
value through profit or loss. MyBank’s accounting policy is to measure listed equities
at fair value, using the mid-price of the bid-ask spread. During our tests of details, we
found that purchases of listed equities were initially recognised at the bid price of the
bid-ask spread and were remeasured to the bid price on the reporting date.
I checked the prior year audit working papers which showed that MyBank measured
fair value in accordance with its accounting policy ie, at the mid-price of the listed
equities.
Issue 4
MyBank holds corporate loans with a principal amount of £270 million. The objective
of the portfolio within which the corporate loans are held is to collect contractual cash
flows. During the year ended 31 July 2019, loans with an outstanding carrying amount
of £40 million suffered an increase in credit risk and MyBank sold these loans before
maturity.
MyBank measures the remaining corporate loans at amortised cost. I think that the
remaining loans should be measured at fair value through other comprehensive
income.
