IFRS 9 Own use scope exemption

IFRS 9 Own use scope exemption

A reduction in the amount of funding available from equity markets, together with difficulty in obtaining loan finance, have meant that a number of developers and producers in the extractives industry have looked to other ways of obtaining finance. An increasingly common approach is to enter into a commodity loan under which a lender advances funds which,instead of being repaid in cash, may be repaid by the delivery of a quantity of a commodity during a specific period. These arrangements have become particularly common when they involve a commodity such as gold, which is traded on an active market. IFRS 9 Own use scope exemption

Key considerations in the application of the IFRS 9 Own use exemptionIFRS 9 Own use scope exemption

The producer’s own production facility

Although it might seem fairly obvious, it is essential that the commodity that is used for the purpose of deliveries under the terms of a commodity loan is extracted from the borrower’s own mining facility. This means that there must be no prospect of the borrower settling part or all of the commodity loan by purchasing commodity on the open market, or from a third party.

This is because the borrower would otherwise be unable to assert that the contract will be settled by the delivery of commodity according to its own expected sale requirements.

Amount of expected future production

In addition to referring to a contract being entered into and continuing to be held for the purpose of delivery of the commodity, IFRS 9 also refers to an entity’s ‘expected purchase, sale or usage requirements’. This means that it is necessary to analyse and link the delivery requirements of a commodity loan to the borrower’s future expected production.

In some cases, this will be straightforward as the expected production from the mining facility will be greater than the amount of commodity required to settle the commodity loan (in some cases, substantially in excess). IFRS 9 Own use scope exemption

However, for an entity in the early stages of exploration or production, it may be difficult to predict with certainty that the amount of commodity required to settle the commodity loan will in fact be extracted. Consequently, due to this uncertainty, these latter arrangements will typically be accounted for as financial instruments.

Timing of expected future production

A commodity loan may contain a clause that requires delivery of the commodity by a specified date. If delivery has not taken place, a cash settlement then becomes due. In these cases, both the amount (see above) and timing of expected production will need to be assessed. IFRS 9 Own use scope exemption

As with the amount of expected future production, for an entity in the early stages of exploration or production, it may be difficult to predict with certainty that the amount of commodity required to settle the commodity loan in each period will in fact be extracted. IFRS 9 Own use scope exemption

Intent and past practice

A producer may be able to demonstrate that the expected production from its own mining facility will be sufficient to settle the commodity loan. However, it is also necessary for the producer to be able to demonstrate that it intends to settle the loan. This could be through an analysis which indicates that the only realistic manner of settlement is physical delivery.

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In addition, where a producer has previously entered into commodity loans, it will be appropriate to analyse the extent to which the producer delivered the commodity and did not either source commodity from third parties, or settle part or all of the arrangement in cash. IFRS 9 Own use scope exemption

While to an extent judgement will be needed, where a producer’s past practice has not been to settle the loan through physical delivery of its own commodity, evidence will be needed to support an assertion that a new commodity loan will be settled through this physical delivery failing which the arrangement will fall within the scope of IFRS 9.

Options

A commodity loan may include an option for the borrower and/or the lender to require settlement in cash, instead of through physical delivery.IFRS 9 Own use scope exemption

If the borrower, rather than the lender, has the choice of whether to settle through physical delivery of in cash, then provided that the producer can demonstrate that it does not intend to exercise the option to settle in cash then the arrangement will not fall within the scope of IFRS 9. This could be through an analysis which indicates that the only realistic manner of settlement is physical delivery. IFRS 9 Own use scope exemption

However, if the lender has an option to require settlement in cash, then the arrangement will automatically fail the assertion that it was entered into and continues to be held for the purpose of the delivery of the commodity, in accordance with the borrower’s expected sale requirements. Consequently it will fail the ‘own use exemption’ and fall within the scope of IFRS 9.

This is because the existence of the option, which can be exercised at the lender’s discretion, means that the borrower does not have control over whether the loan is settled through physical delivery of the commodity. IFRS 9 Own use scope exemption

Unit of account – is it the whole contract or a part of the contract?

A producer might enter into a contract which requires the physical delivery of 100 tonnes of commodity. Although the assessment on inception of the arrangement is that the amount of commodity will be in excess of 100 tonnes in the time period specified in the contract, the expected production subsequently falls to 80 tonnes. The original contract states that, in the event that the producer fails to deliver the required amount of the commodity in the relevant time period, a cash payment will be required for the shortfall.

In these circumstances, at the point at which the expected production falls to 80 tonnes, the entire contract will fail the IFRS 9 ‘own use exemption’ and, prospectively, will be accounted for in accordance with that accounting standard. This is because the unit of account is the contract. Consequently, the arrangement is assessed at that level; it is not appropriate to divide the contract into two components, with one being for 80 tonnes and the other 20 tonnes. IFRS 9 Own use scope exemption

This demonstrates the importance of ensuring that estimates of future production are realistic. It may also mean that in some cases it may be desirable to enter into more than one contract with the lender, with one covering the amount of production that is almost certain, and the other covering the less certain portion.

Changes in settlement terms

A contract which only permits settlement through physical delivery, and has been assessed to meet the IFRS 9 ‘own use exemption’ may have its terms altered, through which the producer and lender agree to gross settlement in cash. IFRS 9 Own use scope exemption

From the point at which the parties agree to settle in cash, the contract will be recognised in accordance with IFRS 9 as it no longer meets the criteria for the ‘own use exemption’.

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Does future production failing to be sufficient to fulfil contractual requirements always result in failure to meet the ‘own use exemption’?IFRS 9 Own use scope exemption

As noted above, commodity loans may contain terms under which, if a producer fails to deliver sufficient quantities of the commodity, the producer will be required to settle the amount due in cash. While these terms need to be taken into account when considering whether the contract meets the IFRS 9 ‘own use exemption’, they do not necessarily mean that it is automatically failed. Instead, it is necessary to analyse the intentions of the producer, together with expected production on inception of the arrangement and subsequent changes.

If a reduction in output and related cash settlement is due to an event that could not have been foreseen at inception of the arrangement (such as an unexpected breakdown at the production facility that meant production was stopped for an extended period), then the cash settlement that arises during this period would not result in the ‘own use exemption’ being failed. This is because the contract was not entered into with the intention of a possible net cash settlement. IFRS 9 Own use scope exemption

However, if a net cash settlement arose because a producer chose to sell its production to another third party, and settle its obligation under the commodity loan through a cash payment, this would result in failure to satisfy the requirements of the IFRS 9 ‘own use exemption’. IFRS 9 Own use scope exemption

Effect of failing the IFRS 9 ‘own use exemption’ after initial recognition

A producer may enter into multiple arrangements that involve the IFRS 9 ‘own use exemption’. Care will be required when assessing the likelihood of the producer continuing to meet the ‘own use exemption’. This is because, in the event that the conditions are breached for one contract, the assertion that the remaining contracts continue to qualify for the ‘own use exemption’ is open to challenge. IFRS 9 Own use scope exemption

The failure to meet the terms of the ‘own use exemption’ may be due to factors outside the producer’s control (for example, an unexpected breakdown of equipment, resulting in an extended period of inactivity in addition to normal maintenance stoppage time). In these cases, provided the physical deliveries for other contracts are still expected to be made, the ‘own use exemption’ is not affected. IFRS 9 Own use scope exemption

However, if the failure to deliver the commodity is due to the producer’s choice, then other contracts under which it has asserted physical delivery of commodity are likely to need to be reclassified to be within the scope of IFRS 9. IFRS 9 Own use scope exemption

IFRS 9 Own use scope exemption

[IFRS 9.2 Scope]

The case:

Entity XYZ enters in to a contract to buy 100 tonnes of copper for CU200/tonne. The IFRS 9 Own use scope exemptioncontract permits XYZ to take physical delivery of the copper at the end of 12 months or to settle net in cash, based on the difference between the spot price in 12 months’ time and CU200/tonne. Entity XYZ has a practice of settling net in cash (i.e. if the copper price at the end of year 1 is CU250/tonne, then Entity XYZ will receive CU50/tonne).

Question: Does the ‘own use’ scope exemption apply?

Analysis: Example IFRS 9 – Applying the ‘own use’ scope exemption

The entity has a practice of settling the contract net therefore the ‘own use’ scope exemption does not apply. Consequently, the contract is within the scope of IFRS 9. The contract contains a derivative because:

  • Fair value of the contract changes in response to changes in the copper price; IFRS 9 Own use scope exemption
  • No initial net investment (no initial cash paid upfront); and IFRS 9 Own use scope exemption
  • Settled at a future date – in 12 months’ time. IFRS 9 Own use scope exemption

Conclusion: Entity XYZ applies derivative accounting for this contract and accounts for the contract at fair value through profit or loss.

Two changes, Entity XYZ:

  • Is a company that manufactures copper wire; and IFRS 9 Own use scope exemption
  • Has a practice of taking delivery of the copper and using it to manufacture copper wires. IFRS 9 Own use scope exemption

Question: Does the ‘own use’ scope exemption apply?

Analysis: Example IFRS 9 – Applying the ‘own use’ scope exemption

The ‘own use’ scope exemption applies because:

  • Entity XYZ is an entity that manufactures copper wires and has a practice of taking delivery of copper and using it for manufacture, so the contract is for its own use requirements;
  • Entity XYZ does not have a practice of settling net.
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Conclusion: Therefore the contract is not within the scope of IFRS 9 and derivative accounting is not applied.

Three changes, Entity XYZ:

  • Usually has sufficient stock of copper to last 3 or 4 months for manufacturing copper wires;
  • Has a practice of settling net when the contract is ‘in the money’ i.e. if the spot copper price is more than the fixed price of CU200 e.g. CU250, it will settle the contract net and receive CU5,000 [(CU250-CU200)X100]; and
  • Has a practice of taking delivery of the copper at CU 200/tonne when the contract is out of the money (i.e. if the spot copper price is less than CU200), because the profit margin on the sale of copper wire more than covers the cost of copper.

Question: Does the ‘own use’ scope exemption apply?

Analysis: Example IFRS 9 – Applying the ‘own use’ scope exemption

The ‘own use’ scope exemption does not apply because although Entity XYZ is an entity that uses copper to manufacture wires, Entity XYZ has a practice of settling net when the contract is in the money.

Conclusion: Therefore the contract is within the scope of IFRS 9; and Entity XYZ accounts for the contract as a derivative.

IFRS 9 Own use scope exemption

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