Problems arising in assessing the application of one of the key scope exemptions applying to financial instruments
Here’s another of the issues discussed in the past by Canada’s IFRS Discussion Group:
- The scope of IFRS 9 Financial Instruments and of IAS 32 Financial Instruments: Presentation include guidance on when certain contracts to buy or sell a non-financial item (e.g., commodities or physical assets) are included or excluded from the requirements in IFRS 9.
- Generally, a contract to buy or sell a non-financial item is not within the scope of IFRS 9. However, certain contracts to buy or sell a non-financial item may be required to be accounted for in accordance with IFRS 9 if those contracts can be settled:
- net in cash or another financial instrument; or
- by exchanging financial instruments, as if the contracts were financial instruments.
- Paragraph 2.6 of IFRS 9 provides examples of ways in which a contract to buy or sell a nonfinancial item can be settled net in cash or another financial instrument or by exchanging financial instruments, some of which look at the entity’s past practice.
- The requirement to follow IFRS 9 for contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument or by exchanging financial instruments is subject to a scope exception, commonly referred to as the “own use” scope exception. This exception is for contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. Own use contracts are accounted for as normal sales or purchase contracts (i.e., executory contracts).
Against this backdrop, the group considered whether or not the scope exemption applies in a couple of hypothetical situations, for instance:
- Entity XYZ enters into a fixed-price forward contract to purchase a million kilograms of gold in accordance with its expected usage requirements. Entity XYZ intends to take delivery to meet its expected usage requirements. The contract does not require an initial upfront payment and is based on the price of gold to be settled at a future date. The contract permits Entity XYZ to take physical delivery of the gold at the end of 12 months or to pay or receive a net settlement in cash, based on the change in fair value of gold.
- Entity XYZ has in the past entered into silver contracts for the purpose of generating a profit from short-term fluctuations in silver prices.
In plain language terms, the point is that if an entity enters into a contact to acquire (say) gold solely because it actually uses gold in its business, then there’s no relevance to users in recognizing the fair value gains and losses on that open contractual position, because there’s no likelihood of them ever crystallizing. But if an entity is playing it in between – perhaps primarily intending to take possession of the gold itself but open to cashing in if that becomes more lucrative – then the relevance of that fair value information clearly increases. The issue here almost seems like another exercise in discerning an entity’s character – if a man has always been faithful to his wife and insists he’ll continue being so, should our expectations change because of knowing how he behaved in the past, with a previous partner?
The group’s view, as it so often is, is that it depends:
- The Group members noted that the fact pattern did not indicate whether the previous experience with silver was similar to that of gold. Some Group members thought one would need to understand the business model better to make a more informed decision.
- One Group member stated that each commodity is different and the entity would need to consider the facts and circumstances of how it uses each commodity. The fact that an entity has historically entered into commodity contracts (silver) with the view of selling the underlying does not automatically preclude the entity from using the exception for contracts in another commodity (gold).
This seems like the only rational answer, but it’s useful to know that the group didn’t set out some kind of draconian “tainting” test. Similar views prevailed in a related scenario it considered, where the entity has in the past taken physical delivery of gold and then sold it for a profit as a result of short-term fluctuations in gold prices, but apparently only because of “an unexpected breakdown of its own production facility.” The group commented:
- …it would be important to understand the reasons that lead to the entity settling the contract net. More information was needed to assess why the entity did not hold the gold until production had restarted. For example, the entity may have limited storage capacity that resulted in the sale, rather than selling the gold to make a profit. Group members also wanted to understand the likelihood of reoccurrence and future plans if there was another breakdown.
If an entity is regularly finding “one-off” reasons for cashing in on an opportunity, then it’s perhaps better to prepare the financial statements on a basis reflecting that recurring economic possibility. But when an entity insists that’s not going to be the case, it might seem overly rigid to discard that assertion in assessing the appropriate accounting, despite a few speckles of past conduct to the contrary. After all, companies aren’t like kids whose word and willpower can’t be trusted. Uh, are they….?
The opinions expressed are solely those of the author