companies at each year end must show details of their pension scheme showing both assets and liabilities.
On the assets side, companies show the amounts held in their pension scheme, comprising equities, bonds, gilts and cash, together with the expected return on these financial instruments. The liabilities are shown as the present value of the scheme’s liabilities, as computed by the company’s actuaries. Where liabilities exceed assets it means there is a deficit and companies show their funding plan to meet such deficit.
Companies sometimes address this deficit by making regular payments into their pension fund. When this happens, the payment will be shown in the Cash Flow Statement, but not in the Income Statement. There may be some charge somewhere in the Income Statement relating to pensions and pension liabilities, but often the disclosures are difficult to interpret. This is yet another reason why the Income Statement as presented under IFRS is not investor friendly as far as shareholders are concerned. Investors are primarily interested in ‘earnings’ defined as the profit available to them and it must be obvious that the net profit shown in the Income Statement does not belong to them if a chunk had to be paid out to reduce the deficit in the company’s pension scheme. However, at least such deficit is shown in the Balance Sheet, so it is now known. In Figure 3.1, note 5 demonstrates these fundamental changes.
Credit risk
Credit risk is to do with a bank holding the company’s liquid assets defaulting and/or the company’s debtors being unable to pay for a variety of reasons. The probability of a major bank defaulting is extremely low, but nevertheless this risk is managed by having accounts with more than one bank. Large companies with many customers can stand the odd one defaulting, so they will take no action to limit this risk. Smaller companies who rely on a relatively small numbers of customers will take out insurance to cover both their UK and foreign customers.
Currency risk
Imagine a company has contracted to buy a quantity of a particular raw material costing $1 million in total, for delivery and payment in 6 months time. The material is to be used to manufacture 1000 tonnes of a chemical with a selling price of £900 per tonne. Other raw materials used to manufacture the chemical are paid in sterling and amount to £107 per tonne. At the time the order for the main material was placed, the exchange rate was $1.95 to £1.00, so that the total raw material cost is £620 per tonne, giving a margin of £280 per tonne.
The company might take the currency risk and do nothing and there could be three possible outcomes:
• The pound weakens so there are less dollars to the pound, in which case the raw material price increases, which could put the company into a loss-making situation.
• The exchange rate does not change much, so the margin is roughly main- tained.
• The pound strengthens the dollar again, thereby reducing the material cost per tonne and increasing the company’s profitability.
However, the company is a chemical manufacturer, not a currency trader, and therefore will not want to take risks. Accordingly, imagine it has two options:
• To buy $1 000 000 forward at a fixed rate of $1.891 to £1.00 in 6 months from the date of the contract; or
• Buy an option to buy $1 000 000 at the spot rate of $1.950 anytime
be guaranteed. On the other hand, if the company chose to buy the option, then the worse case scenario is that the raw material cost would increase by
£24 per tonne. The risk of taking the option, rather than the forward contract, would be £8000, a gamble that would pay off if the spot rate went to $1.981 to
£1.00, or higher.
Now let us imagine that at the company’s year end, three months from the date of the contract, the spot rate was $2.00 to £1.00 and the company had bought the option. The trend is that the dollar is weakening and the Finance Director believes that it will continue to do so; accordingly, he does not want to exercise the option at the company’s year end. The question is: what goes into the accounts?
There can be several views as to how these events might be treated:
• As the spot rate at the date of the contract was $1.95 to £1.00 and margins were worked out on this basis, then the £24 000 cost of the option should be written off to administrative expenses. This is the most prudent view.
• As the company does not take risks, the margins to be taken in the following year should take account of the forward rate (fixed rate) of
$1.891 to £1.00. Therefore, only £8000 should be charged to administra- tive expenses, this being the difference between the worst possible and contracting at the forward rate.
The difficulty here is that different companies could not be relied upon to come up with the same interpretation, so the IASB felt it necessary to be prescriptive for the sake of consistency. They determined that financial derivatives should be valued at ‘fair value’. In our example, the ‘fair value’ of our financial deriva- tive would be £12 821, being the difference of $1 000 000 at the strike price of
$1.95 to £1.00 and the closing price of $2.00 to £1.00.
Interest rate risk
Companies often borrow money at a fixed number of percentage points over base rate, which means they have a variable rate of interest as the base rate can change. Guessing what the base rate might be in future is, of course, a gamble.
Companies can hedge this risk by swapping their variable rate borrowings for a fixed rate loan. Obviously, at the time the deal is struck, there will be a cost to the company, which will be equal to the bank’s (the one agreeing the swap) valuation of the risks involved, together with their profit margin. Again under
IFRS, all these derivatives must be assessed at the year end and valued at their perceived ‘fair value’.
In Figure 3.2, the figure shown as ‘financial instruments’ represents a liability in connection with foreign currency hedging, not recognised under UK GAAP.