Accounting for financial instruments will be seeing some significant change in the coming years as the
IASB’s projects in this area reach completion. IFRS 9 has already been published as a final standard and is mandatorily applicable from 2015. Few entities have early adopted IFRS 9; it is not yet available for adoption within the European Union as it has not been endorsed.
Accordingly, this section is presented based on the current requirements of IAS 39 and does not address any changes that may be necessary once IFRS 9 is applicable.
The requirements of IFRS 9 are instead discussed in Future Developments Section 17.2. IFRS 13 “Fair Value Measurement” issued in May 2011, mandatorily applicable from 2013, is also discussed in section 17.1.
IFRS 13 is unlikely to result in substantial change as it is largely consistent with current valuation practices. The IASB also have an ongoing project on hedge accounting that may result in simplification in current requirements, however, a final standard is yet to be issued.
The accounting for financial instruments can have a major impact on a mining entity’s financial statements.
Some entities have specific commodity trading activities and those are discussed in section 14.6. Many entities use a range of derivatives to manage the commodity, currency and interest-rate risks to which they are operationally exposed. Other, less obvious, sources of financial instruments issues arise through both the scope of IAS 39 and the rules around accounting for embedded derivatives. Many entities that are solely engaged in producing, refining and selling commodities may be party to commercial contracts that are either wholly within the scope of IAS 39 or contain embedded derivatives from pricing formulas or currency.
14.1.1 Scope of IAS 39
Contracts to buy or sell a non-financial item, such as a commodity, that can be settled net in cash or another financial instrument, or by exchanging financial instruments, are within the scope of IAS 39. They are accounted for as derivatives and are marked to market through the income statement. Contracts that are for an entity’s ‘own use’ are exempt from the requirements of IAS 39 but these ‘own use’ contracts may include embedded derivatives that may be required to be separately accounted for. An ‘own use’ contract is one that was entered into and continues to be held for the purpose of the receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements. In other words, it will result in physical delivery of the commodity. Some practical considerations for the own use assessment are included in section 14.6.
The ‘net settlement’ notion in IAS 39 para 6 is quite broad. A contract to buy or sell a non-financial item can be net settled in any of the following ways:
a) the terms of the contract permit either party to settle it net in cash or another financial instrument;
b) the entity has a practice of settling similar contracts net, whether:
– with the counterparty;
– by entering into offsetting contracts; or
– by selling the contract before its exercise or lapse;
c) the entity has a practice, for similar items, of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin; or
d) the commodity that is the subject of the contract is readily convertible to cash [IAS 39 para 6].
The process for determining the accounting for a commodity contract can be summarised in the following decision tree:
Commodity contracts decision tree (IAS 39)
Financial Item Non-financial Item
YES NO
YES
YES
YES YES
YES NO
NO
NO
NO NO
IAS 39.5 & 6 (a-d)
Can the contract be settled net in cash or another financial instrument or by exchanging financial instruments?
IAS 39.9
Is the contract a derivative?
a) Does it have an underlying
b) Does it require little or no initial net investment?
c) Does it settle at a future date?
Host contract out of scope
Are there embedded derivatives?
Fair value embedded through the P&L and accruals account for host OR
Designate whole contract at fair value through the P&L IAS 39.7
Is the contract a written option?
Does it contain
a premium? IAS 39.5 & 6 (a-d)
Is contract held for receipt/delivery for own purchase/sale or usage requirements?
Cannot qualify for the own use exemption
Fair value through the P&L (held for trading)
Cash flow hedge accounting through equity
Accrual accounting Consider hedge
accounting
14.1.2 Application of ‘own use’
‘Own use’ applies to those contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item. The practice of settling similar contracts net (in cash or by exchanging another financial instrument) can prevent an entire category of contracts from qualifying for the ‘own use’ treatment (i.e., all similar contracts must then be recognised as derivatives at fair value). A level of judgement will be required in this area as net settlements caused by unique events beyond management’s control may not necessarily prevent the entity from applying the
‘own use’ exemption to all similar contracts. This should be assessed on a case by case situation. Judgement will also be required on what constitutes “similar” in the context of the ‘own use’ assessment—contracts with
“similar” legal terms may be “dissimilar” if they are clearly segregated from each other from inception via book structure.
A contract that falls into IAS 39 para 6(b) or (c) cannot qualify for ‘own use’ treatment. These contracts must
be accounted for as derivatives at fair value. Contracts subject to the criteria described in (a) or (d) are evaluated to see if they qualify for ‘own use’ treatment.
Many contracts for commodities such as gold, copper and other mineral ore meet the criterion in IAS 39 para 6(d) (i.e., readily convertible to cash) when there is an active market for the commodity. An active market exists when prices are publicly available on a regular basis and those prices represent regularly occurring arm’s length transactions between willing buyers and willing sellers.
Consequently, sale and purchase contracts for commodities in locations where an active market exists must be accounted for at fair value unless ‘own use’ treatment can be evidenced. An entity’s policies, procedures and internal controls are critical in
determining the appropriate treatment of its commodity contracts. It is important to match the own use contracts with the physical needs for a commodity by the entity.
A well-managed process around forecasting these physical levels and matching them to contracts are both very important.
‘Own use’ contracts Background
Entity A owns a copper mine and enters into a fixed price forward contract to sell one million kilograms of copper in accordance with a counterparty’s expected usage requirements. The contract permits physical delivery of the copper at the end of the 12 months or payment of a net settlement in cash based on the change in the fair value of copper during the 12 month period. The counterparty cannot choose to refuse delivery.
A intends to settle the contract by delivering the copper, has no history of settling similar contracts net in cash and has sufficient production capacity to provide the required quantity of copper to meet the delivery requirements.
From entity A’s perspective, is this contract an ‘own use’ contract?
Solution
The ‘own use’ criteria are likely to be met. There is an embedded derivative (being the net settlement provision based on the change in the fair value of copper) but it does not require separation. See further discussion of embedded derivatives at section 14.4.
Although the contract allows net settlement the contract will still qualify as ‘own use’ as long as it has been entered into and continues to be held for the expected counterparties’ sales/usage requirements. However, if there is volume flexibility then the contract is to be regarded as a written option. A written option is not entered into for ‘own use’.
Therefore, although the contract may be considered net settled, it can still claim an ‘own use’ exemption provided the contract is entered into and is continued to held for the parties own usage requirements.
‘Own use’ is not an election. A contract that meets the
‘own use’ criteria cannot be selectively fair valued unless it otherwise falls into the scope of IAS 39.
A written option to buy or sell a non-financial item that can be settled net cannot be considered to be entered into for the purpose of the receipt or delivery of the non- financial item in accordance with the entity’s expected purchase, sale or usage requirements. This is because an option written by the entity is outside its control as to whether the holder will exercise or not. Such contracts are, therefore, always within the scope of IAS 32 and IAS 39 [IAS 32 para 10; IAS 39 para 7]. Volume adjustment features are also common, particularly within commodity contracts and are discussed within section 14.3.
If an ‘own use’ contract contains one or more embedded derivatives, an entity may designate the entire hybrid contract as a financial asset or financial liability at fair value through profit or loss unless:
a) the embedded derivative(s) does not significantly modify the cash flows of the contract; or
b) it is clear with little or no analysis that separation of the embedded derivative is prohibited
[IAS 39 para 11A]
Further discussion of embedded derivatives is presented in section 14.4.