Olc Supplement Chapter 10

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OLC SUPPLEMENT – CHAPTER 10

FINANCIAL INSTRUMENTS

After reading this supplement you will understand the important differences among financial instruments. A financial instrument can be defined as any contract that gives rise to both a financial asset of one party (such as cash or a receivable) and a financial liability or an equity instrument of another party (such as common shares). From Chapter 10, you have a good understanding of loans and mortgages, which are single-creditor financial instruments as well as bonds and debentures, which are multiple-creditor financial instruments. Together these four types of liabilities comprise primary financial instruments.

There is, however, another class of financial instruments called secondary financial instruments. While primary financial instruments are often used to finance the acquisition of long-term capacity, secondary financial instruments spread future financial risks that may confront one corporation among other willing parties for an agreed upon price that is payable in the future when the risks have materialized. Before proceeding further, however, it is important for an accountant to understand what secondary financial instruments are and how the value of any potential liability can be estimated.

Similar to debt contracts, secondary financial instrument contracts specify a cost to each party that enters into the contract, the value covered by the contract, the date at which the contract expires, and the manner in which the parties will fulfill their obligations at the termination date. The most well known financial instruments are derivatives (defined below). Various types of derivative contracts are traded in active markets.

The accountant needs to understand how best to apply generally accepted accounting principles in order to analyze, record, classify, and disclose the fair value of liabilities such as derivatives in a manner that enables readers to analyze the information and assess the financial health of the company.

Derivatives

A derivative is a legal contract between two or more parties that fixes the future date and the price at which some specified transaction will occur. It is called a derivative because the value of a derivative contract is always based on, or derived from the value of some underlying asset or liability. The transaction defined in a derivative contract may be a purchase or sale of a commodity such as oil, or a trade such as an interest rate swap (defined later). A derivative provides one way for corporations to hedge or limit their exposure to one financial risk by taking on an offsetting financial risk. It is similar to other debt contracts because it fixes the terms of payment between two parties. However, where most debt contracts assure the transfer of money from one party to another, a derivative either transfers or spreads the risk of the loss of cash from one party to other parties. What follows is a summary of simple forms of derivative contracts to which a corporation might be a party.

Options

An option contract specifies the rights to buy or sell assets, including securities, but impose different obligations on the buyer and the seller. The option buyer has the choice to exercise the option at some future date, although the buyer must pay the cost of purchasing the option. Corporations can buy options to sell assets or buy options to buy assets. In both cases, the corporation is the buyer of an option. The seller or writer of an option will have no choice in the future but to fulfill the terms of the contract if the buyer exercises the option. Corporations may also decide to be writers of options. Thus, the liability status of this type of derivative will differ depending on whether the corporation is the buyer or writer of an option contract. As a buyer, the corporation has no liability other than the cash paid to purchase the option. As a seller, however, the corporation incurs a contingent liability to fulfill the terms of the contract. Financial models, in particular the Black and Scholes options pricing model, are used to estimate the future value of the liability associated with the option.

Futures

AFutures contract specifies the terms under which assets, such as barrels of oil or bushels of wheat, will bepurchased and sold at a specified future date. The obligations of parties to a futures contract are symmetrical because there is no choice about the future purchase or sale by the contracting parties. In other words, if the conditions for the exchange are favourable to the buyer, they will be unfavourable to the seller, and vice versa. The price of the future transaction is derived from the value of the underlying asset(s) upon which the contract is based. Futures contracts are marked to market daily, meaning that every day the difference between the contract price and the fair market value must be paid for by the "losing" party in the contract. These payments are made into a fund (similar to the idea of a sinking fund for debt obligations) in order to ensure that the terms of the contract will be fulfilled by the contracting parties when the contract expires. Both futures contracts and options contracts are traded in secondary markets throughout the world.

Forward Contracts

Forward contracts specify the terms under which the contracting parties exchange financial instruments at a future date. For example, the buyer may purchase a six-month forward contract whereby a promise is made to deliver $1,000,000 cash in exchange for $1,000,000 face value of fixed-rate government bonds. Conversely, the seller of the contract promises to deliver $1,000,000 face value of fixed-rate government bonds in exchange for $1,000,000 cash. Forward contracts differ from other contracts because they are not liquid and do not trade in secondary markets as corporations usually enter into forwards with well established financial institutions. They are private contracts that are not marked to market daily, which creates an additional risk that the losing party may default. Interest rate swaps and currency swaps are the most common forward contracts. While the Canadian standards of accounting disclosure for derivatives have only been in force since 1995, swap contracts have been used to hedge interest rate risk for decades.

Interest Rate Swaps

An interest rate swap is a forward contract in which the parties agree to make a series of future exchanges of cash amounts, one amount is calculated with reference to a variable or floating interest rate and the other with reference to a fixed interest rate. As you know, interest obligations require the corporation to make future cash payments. The predictability of these payments depends on the terms of the debt contract. That is, some debt contracts carry a fixed interest rate on a specified debt for which the obligation is precise, while other contracts carry a variable interest rate for which the obligation is somewhat predictable. We know that market interest rates do change over time. Therefore, if a corporation has a fixed interest rate debt, and the market interest rate falls, then the corporation can incur substantial opportunity costs to service its debt. Managers can do sensitivity analyses to estimate the extent to which the corporation can bear this opportunity cost. If it seems probable this threshold will be exceeded, then the managers can reduce the corporation’s downside risk by entering into swap contracts with holders of variable interest rate debt contracts. Usually a financial institution such as a bank acts as an intermediary between the two parties and receives a fee for its service.

The floating interest expense on a swap is based on a fluctuating interest rate index, usually LIBOR (London InterBank Offered Rate). Each party then agrees to pay the cash value of the interest payment to the other party at a specific future date. The corporation that agrees to exchange its fixed interest payments for variable interest payments of another party faces the risk that LIBOR may be higher when the contract terminates. In this case, the actual cash required to fulfil the corporation’s obligation will be higher than what was estimated at the contracting date, which would be unfavourable to the corporation. On the other hand, if LIBOR falls relative to the rate when the contract was signed, the variable rate obligation will be lower than the amount estimated at the contracting date, and the corporation benefits from entering into the swap contact.[1]

Disclosures

For the accountant, a further challenge is how to disclose these swap contracts. A potential financial asset or liability will arise from the swap contract depending on how interest rates fluctuate relative to the index used in the swap. These potential assets and liabilities are not recorded on the balance sheet of the corporation. Hence, a swap is a form of off-balance sheet financing. The swap clearly gives rise to a future cash liability for both contracting parties, but the dollar value of this future liability may be uncertain. Derivatives such as options and swaps pose a challenge for reporting and disclosure purposes. The reason is that for an option and a swap, the actual market value fluctuates relative to the contracted amounts. As we noted above for a swap, the actual future liability to the writer of an option contract or to the holder of a variable interest rate swap may be higher than contracted values in these agreements. A loss on the derivative contract occurs if the actual interest expense is higher than expected. If the actual interest expense is lower that previously expected, then a gain is realized on the derivative contract.

Unfortunately, the timing of the termination of derivative contracts rarely coincides with the timing of mandatory financial disclosure. Hence at the date of financial disclosure, the value of the derivative contract must be marked to market along with disclosure of any related gain or loss even though it remains unrealized as at that date. When the swap contract terminates and the cash gain or loss is subsequently realized, the accountant must make an adjusting entry to interest expense. In reality, the situation is much more complex because corporations holding swap contracts can agree, in some instances, to terminate them and enter into new ones. What is important for the accountant to understand is that swaps are derivative contracts to which GAAP must be applied. Petro-Canada, the focus company of Chapter 10, disclosed the following about its derivative financial instruments:

Note 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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(p) Hedging and Derivative Financial Instruments

The Company may use derivative financial instruments to manage its exposure to market risks resulting from fluctuations in foreign exchange rates, interest rates and commodity prices. These derivative financial instruments are not used for speculative purposes and a system of controls is maintained that includes a policy covering the authorization, reporting and monitoring of derivative activity.

The Company formally documents all derivative instruments designated as hedges, the risk management objective, and the strategy for undertaking the hedge.

Gains and losses on derivatives that are designated as and determined to be effective hedges are deferred and recognized in the period of settlement as a component of the related transaction. The Company assesses both at inception and over the term of the hedging relationship, whether the derivative instruments used in the hedging transactions are highly effective in offsetting changes in the fair value or cash flows of hedged items. If a derivative instrument ceases to be effective or is terminated, hedge accounting is discontinued. The accumulated gains and losses continue to be deferred and recognized in the Consolidated Statement of Earnings in the period of settlement of the related transaction; future gains or losses are recognized in the Consolidated Statement of Earnings in the period they occur.

Derivative instruments that are not designated as hedges for accounting purposes are recorded on the Consolidated Balance Sheet at fair value with any resulting gain or loss recognized in the Consolidated Statement of Earnings in the current period.

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Note 2. CHANGES IN ACCOUNTING POLICIES

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Hedging Relationships

Effective January 1, 2004, the Company adopted Accounting Guideline 13 (AcG 13) “Hedging Relationships” which resulted in changes to the conditions as to when hedge accounting may be obtained. As a result, certain of the Company’s risk managementderivative instruments no longer qualify as accounting hedges and are accounted for as required under Emerging IssuesCommittee (EIC) 128, “Accounting for Trading, Speculative or Non-Hedging Derivative Financial Instruments.” EIC 128requires that all derivative instruments that do not qualify or are not designated as a hedge under AcG 13 berecorded on thebalance sheet at fair value as either an asset or liability with changes in fair value recognized in earnings (see Note 23 to theConsolidated Financial Statements).

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Note 23.FINANCIAL INSTRUMENTS AND DERIVATIVES

The Company is exposed to market risks resulting from fluctuations in commodity prices, foreign exchange rates andinterest rates in the course of its normal business operations. The Company monitors its exposure to market fluctuations andmay use derivative instruments to manage these risks, as it considers appropriate.

Crude Oil and Products

The Company enters into forward contracts and options to reduce exposure to Downstream margin fluctuations, includingmargins on fixed-price product sales, and short-term price fluctuations on the purchase of foreign and domestic crude oil andrefined products.

The Company has also entered into a series of forward sales contracts for the future sale of Brent crude oil in connectionwith its 2004 acquisition of an interest in the Buzzard field in the U.K. sector of the North Sea (see Note 15 to theConsolidated Financial Statements).

The Company’s outstanding contracts for derivative instruments and the related fair values at December 31, 2004 wereas follows:

Average Price Unrealized

Quantity Maturity US$/bbl Gain/(Loss)

Crude Oil and Products (millions of barrels)

Crude oil purchase 2.7 2005 $ 40.33 $ 4

Buzzard crude oil sales 35.8 2007-2010 $ 25.98 $ (333)

$ (329)

As at December 31, 2004, the unrealized loss on derivative contracts has decreased investment and other income by $329 millionand increased accounts receivable, accounts payable and accrued liabilities, and other liabilities by $5 million, $1 million and$333 million, respectively.

The fair value of these derivative instruments is based on quotes provided by brokers, which represents an approximationof amounts that would be received or paid to counterparties to settle these instruments prior to maturity.The Company plansto hold all derivative instruments outstanding at December 31, 2004 to maturity.

Derivative and financial instruments involve a degree of credit risk. The Company manages this risk through the establishmentof credit policies and limits which are applied in the selection of counterparties. Market risk relating to changes in value orsettlement cost of the Company’s derivative instruments is essentially offset by gains or losses on the hedged positions.

In addition to the derivative instruments described above, the Consolidated Balance Sheet includes other items consideredto be financial instruments, such as cash, accounts receivable, accounts payable and accrued liabilities and notes payable. Thefair values of these other financial instruments included in the Consolidated Balance Sheet are as follows:

2004 2003

Carrying Amount Fair Value Carrying Amount Fair Value

Financial instruments included in current

assets and current liabilities $ (1,098) $ (1,098) $ 316 $ 316

Long-term debt $ (2,281) $ (2,538) $ (2,229) $ (2,432)

The fair value of financial instruments included in current assets and current liabilities, excluding the current portion of long-termdebt, approximates the carrying amount of these instruments due to their short maturity. The fair value of long-term debt isbased on publicly quoted market values.

Notice that BCE states not only the variety of derivatives and their underlying primary financial instruments, but also how each potential outcome of its derivative contracts is recorded and disclosed. In each case the qualitative and quantitative disclosures comply with GAAP requirements in effect in the year 2004.

One barrier to generating more detailed standards regarding measurement of financial instruments is the rapidity with which complex derivative instruments are invented to respond to financial market demand. Unlike changes in derivative financial instruments, regulation and standard setting is a protracted process of building consensus among those stakeholders who may be affected by a new or amended standard. By the time consensus can be achieved, the economic substance of derivative financial instruments often falls beyond the domain of these standards and regulations. If you do a search at on the keywords FAS 133 you will find that the FASB, which is the U.S. counterpart to the CICA, has generated substantial controversy as it continues to amend and reverse its standards.

Despite these controversies and the dynamic nature of derivatives, the number of Canadian companies that have complied with the current CICA requirements as outlined in section 3860.78 of the CICA Handbook has increased steadily. According to Financial Reporting in Canada 2005, each of the 200 companies surveyed provided the required disclosures in their annual reports for fiscal year 2004.[2]

[1] Interest rate swap agreements can also involve different currencies wherein the fixed and floating rate liabilities are swapped in different currencies (e.g., fixed interest payments in Canadian dollars are exchanged for floating interest payments in Euros). In cross-currency interest swaps, the index is usually related to the currency in which the swap will occur.

[2] In April 2005, the Accounting Standards Board completed its financial instruments project and issued new Handbook Sections 1530 (Comprehensive Income), 3855 (Financial Instruments – Recognition and Measurement) and 3865 (Hedges). These Handbook Sections affected the content of Section 3860, which necessitated its withdrawal and replacement by the new Section 3861. The requirements of these new Sections are effective for public companies with fiscal years beginning on or after October 1, 2006.