A recent European example of issues related to the cash flow statement, and an example of applying a prominent financial instrument exemption

Here’s another of the issues from some extracts of enforcement decisions recently issued by the European Securities and Markets Authority (ESMA) (for more background see here):

• “The issuer operates in the mining industry and sells some of the production from its mines to a bank, under the terms of a fixed-price forward contract. The forward contract was initially set-up as a condition for obtaining financing from the bank in order to develop the mines; it is, however, a separate contract and repayment of the loan is independent from the level of production and the spot price of the commodity produced.
• The issuer did not account for the forward contract as a derivative as it assessed that the contract fulfilled the own use exemption in paragraph 5 of IAS 39 – Financial Instruments: Recognition and Measurement. Sales under the contract were accounted for according to IAS 18 – Revenue instead.
• During 2011, the issuer disposed of all of its operations in one region. As a result, there was a possibility that it would no longer be able to fulfil its supply obligations under the forward contract in periods when its production was lower. There was a risk that the issuer would have to make purchases on the spot market. It made, therefore, a one-off payment to the bank to reduce the notional amount of the forward contract.
• The issuer classified the one-off payment in its cash flow statement as an outflow from financing activities because it did not consider the payment to be part of its operating activities. It also considered it to be relevant that the counterparty to the payment was the bank that provided the issuer with financing.
• The issuer did not believe that this payment indicated that there was a change in the nature of the forward contract and continued to account for sales according to IAS 18.”

The enforcer (as ESMA likes to term it) disagreed with this treatment, viewing the cash outflow as an operating item instead. It explains: “Paragraph 6 of IAS 7 defines financing activities as those that result in changes in the size and composition of the contributed equity and borrowings of the entity. The forward contract was not directly linked to the loan contract and was not recognized on the statement of financial position as part of borrowings. The payment did not, therefore, affect the issuer’s equity or borrowings. In addition, recurring cash receipts from sales under the contract were considered operating cash inflows. The one-off cash payment adjusted future cash inflows under the contract. Treating the cash outflow as an operating activity ensures that cash flows having the same nature are treated consistently.”

Ambiguities of cash flows

Variations on this issue can certainly arise in Canada, in situations where cash flows may in some way be related to activities that meet the IAS 7.6 definition above, without necessarily meeting that definition in themselves. For example, as part of a financing transaction, an issuer might be required to convert some of its cash into another form of financial asset as collateral: that action doesn’t in itself change the entity’s borrowings, but is only happening because of something that does, so its treatment as financing versus investing may sometimes seem ambiguous. For another kind of example, issuers may be inclined to regard various kinds of payments as “investments” in their future, even if they’re not treated as assets on the balance sheet; IAS 7.16 specifies though that such items aren’t eligible to be classified as investing activities. Of course, these kinds of matters can be especially sensitive when operating cash flow constitutes a key performance measure, as it often does.

The “own use” exemption

In this case though, the set-up to the issue is more potentially interesting than the issue itself. In broad terms, the rationale underlying the “own use” exemption (by which contracts entered into for the purpose of receiving or delivering a non-financial item in accordance with an entity’s expected purchase, sale or usage requirements are excluded from the scope of IAS 39) seems to be that the fair value of certain contracts can be considered to be irrelevant to a user of the financial statements, where nothing about the purpose for entering into those contracts indicates that this fair value would ever be realized, and where the information therefore doesn’t contribute anything to understanding financial position or performance.

This rationale can come under some strain though when an entity is at an early stage, and where it’ s plain that the contracts arise as a condition of obtaining finance, rather than (say) to secure a normal sales channel. In such cases, the contracts are perhaps more likely to contain terms that make the purpose ambiguous, or because there’s no history, it may be harder to conclude how the contracts will work in practice (as in the ESMA example); consequently, the fair value of those positions may be more significant in understanding the strengths or weaknesses of the issuer’s position relative to the market.

But because IAS 39 only contains so much detail on the matter, it’s possible different practitioners might assess this in different ways. It wouldn’t be a great surprise if this was in itself the subject of future commentary, from ESMA or elsewhere.

The opinions expressed are solely those of the author