OLC SUPPLEMENT – CHAPTER 10 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). Primary financial instruments have been introduced throughout the text. The focus of this supplement is secondary financial instruments, which are contracts that specify (1) a cost to each party that enters into the contract, (2) the value covered by the contract, (3) the date at which the contract expires, and (4) the manner in which the parties will fulfill their obligations at the termination date. These contracts are designed specifically to spread future financial risks among several willing parties at an agreed upon price that is payable in the future when the risks have materialized. Action by the contracting parties will be determined at some future date and will depend on both what actually occurs and what the contract permits. Nevertheless, the signing of the contract is the transaction that triggers the requirement to estimate and recognize its value. The most well known financial instruments are derivatives (defined below). Various types of derivative contracts are traded in active financial markets. Derivatives A derivative is a legal contract between two or more parties. They are called derivatives because their value is always based on, or derived from the value of some underlying rate (e.g., interest or foreign currency rate), price (e.g., commodity price such as silver or pork bellies), credit rating, (e.g., Standard & Poor’s or Moody’s ratings), or credit index (e.g., LIBOR). For a financial instrument to qualify as a derivative it must require no initial investment; its value must change in response to some specific underlying item; and it must be settled at a future date. A derivative provides one way for corporations to hedge or limit their exposure to one financial risk by taking on an offsetting financial risk. 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. More complex forms of derivatives are covered in finance courses and in advanced financial accounting courses. Options An option contract specifies the rights to buy or sell assets, including securities, but imposes 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 (a call) or buy options to purchase assets (a put). In both cases, the corporation is the buyer of the option. Its only obligation is the payment of cash for the purchase. The corporation (buyer) can choose what action to take at a future date, but this is not true for the seller or writer of an option that will have no choice in the future but to fulfill the terms of the contract if the buyer exercises the option. 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. 2 Corporations may also decide to be writers of options but global legislation requires exceptional financial strength of the options writers to assure option buyers that the writers will not default on their liabilities. Forward Contracts Forward contracts specify the terms under which the contracting parties undertake an exchange 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 writer of the contract promises to deliver $1,000,000 face value of fixed-rate government bonds in exchange for $1,000,000 cash. At the date of the exchange if the market price of the bonds exceeds $1,000,000, conditions are favourable to the buyer that pays only $1,000,000 for a bond of higher value. At the same time, the writer suffers a loss because $1,000,000 is received in exchange for a bond with a higher value. Forward contracts differ from other secondary financial instrument 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. Futures contracts A futures contract is a forward contract that specifies the terms under which assets, such as barrels of oil or bushels of wheat, will be purchased 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 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 parties must post collateral to prevent credit default. Both futures contracts and options contracts are traded in secondary markets throughout the world. Interest Rate Swaps An interest rate swap is a specific type of futures contract in which the parties agree to make a series of future exchanges of cash amounts on specific dates. Recall that debt obligations require the corporation to make future interest payments. The predictability of these payments depends on the terms of the debt contract. Some debt contracts carry a fixed interest rate on a specified debt, resulting in fixed interest payment, while other contracts carry a variable interest rate, making the interest payment somewhat predictable. Since market interest rates do change over time, a corporation that has a fixed interest rate debt can incur substantial opportunity costs to service its debt when interest rates fall. Managers can do sensitivity analyses to estimate the extent to which the corporation can bear this opportunity cost and then establish a threshold beyond which the corporation is unwilling to bear the opportunity loss. If it seems probable this threshold will be exceeded, then the managers can enter into a swap contract, thereby hedging the risk associated with expected future changes in interest rates that may be unfavourable to the 3 corporation’s cash flow situation. 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 benchmark such as 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 the 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 fulfill 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 contract.1 Foreign Currency Swaps Corporations may issue debt instruments that are denominated in various foreign currencies (e.g., U.S. dollar, euro, Japanese yen). They do so in order to access the capital markets in different countries and to reduce the risk associated with changing foreign currency exchange rates, particularly if they have significant operations in foreign countries. Other corporations also enter into purchase and sales contracts with payments to be made in various foreign currencies. These corporations become exposed to fluctuations in cash flow because of foreign currency fluctuations. To mitigate the effects of exchange rate fluctuations, corporations enter into foreign currency swaps where payments in one currency are exchanged for payments in another currency at a future date. In essence, these swaps are derivatives that convert fluctuating or floating cash flows into a fixed amount. Embedded Derivatives Financial contracts do not all fall neatly into primary and secondary financial instrument classifications. Some contracts are hybrids or a mix of primary and secondary financial instruments, but their economic substance is that cash flow will vary similar to a pure derivative contract. Hence, the embedded derivative portion of the contract must be recognized and measured at fair value. For example, some primary debt contracts may specify an interest rate or principal payment based on changes in an underlying rate, security price, commodity price, index, or currency. The interest or principal payment is an embedded derivative in the debt contract and must be separated and accounted for as a derivative. Bonds may include a call option to acquire common shares of the corporation that issued the bonds. The call option is an embedded derivative. A second example is when a Canadian company enters into a lease contract where payments are made in US dollars. Payment in a foreign currency is an embedded derivative. Another example would be a contract to purchase specific resources from a supplier. If the price of the resource is dependent on changes in the LIBOR index, then the price is an embedded derivative. Finally, corporations may agree to swap resources, a non-financial contract, with the quantities dependent upon their relative values at some future date. If the value of the resource is tied to an underlying price, rate, or index, then this non-financial contract 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. 4 contains an embedded derivative which must be accounted for as a secondary financial instrument. The objective of identifying such contracts as embedded derivatives is to ensure that all derivatives will be recognized at fair value on the balance sheet and all gains and losses appear on the income statement. Accounting for Derivatives Accounting for secondary financial instruments is complex in large part because the cash flows associated with the execution of these contracts occur in the future and the actual gains or losses are not known with certainty until the settlement of the contract. Until recently, Canadian accounting standards for financial instruments failed to include when a financial instrument should be recognized on the balance sheet and how its value should be estimated once it has been recognized. The reason was that unlike primary financial instruments, most derivative contracts cost nothing and yet there is an active trading market in these contracts. These contracts were then kept off the balance sheet. Yet, derivative contracts can be traded at their market value at any time. The new accounting standards related to financial instruments, specifically section 3855 of the CICA Handbook, no longer permits off balance-sheet treatment of these instruments. Instead, financial assets and liabilities must be measured at their fair value and reported on the balance sheet. Derivative liabilities can only be removed when the contracts either expire or are cancelled or discharged. In addition, gains and losses related to financial instruments must be recognized on the income statement during the period they arise. Specific details related to the initial recognition and subsequent measurement of financial instruments are covered in advanced accounting courses. Disclosures 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 on the income statement even though the gain or loss remains unrealized as at that date. Such gains or losses are reported as a component of Comprehensive Income.2 When the derivative contract terminates and the actual gain or loss is subsequently realized, the accountant must adjust the various accounts that relate to the contract and determine the actual gain or loss on the contract. In reality, the situation is much more complex because corporations holding derivative contracts can agree, in some instances, to terminate them and enter into new ones. The disclosures made by Petro-Canada, the focus company of Chapter 10, in its annual report for 2007 illustrate the complexity of this topic. 2 See OLC Supplement – Comprehensive Income for more details. 5 Note 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ... q) Financial Instruments All financial instruments are initially recognized at fair value on the balance sheet. The Company has classified each financial instrument into one of the following categories: held-for-trading financial assets and liabilities, loans and receivables, held-to-maturity financial assets and other financial liabilities. Subsequent measurement of financial instruments is based on their classification. Held-for-trading financial assets and liabilities are subsequently measured at fair value with changes in those fair values recognized in net earnings. Loans and receivables, held-to-maturity financial assets and other financial liabilities are subsequently measured at amortized cost using the effective interest method. The Company classifies cash and cash equivalents as held-for-trading financial assets, accounts receivable as loans and receivables, and accounts payable and accrued liabilities, short-term notes payable and long-term debt as other financial liabilities. The Company combines transaction costs and premiums or discounts directly attributable to the issuance of longterm debt with the fair value of the debt and amortizes these amounts to earnings using the effective interest method. The Company classifies financial instruments that are derivative contracts as held-for-trading financial assets and liabilities unless designated as effective hedges. r) Hedging and Derivatives The Company may use derivative contracts to manage its exposure to market risks resulting from fluctuations in foreign exchange rates, interest rates and commodity prices. These derivative contracts 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. Derivative contracts 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 investment and other income (expense) on the Consolidated Statement of Earnings. The Company formally documents all derivative contracts designated as hedges, the risk management objective and the strategy for undertaking the hedge. For designated cash flow hedges, the portion of the gain (loss) on the hedging item that is deemed to be effective is recognized as other comprehensive income (loss), net of tax, in the Consolidated Statement of Comprehensive Income, and is then reclassified to the Consolidated Statement of Earnings in the same period or periods during which the hedged item affects net earnings. The portion of the gain (loss) that is deemed to be ineffective is recognized immediately in net earnings on the Consolidated Statement of Earnings in the period in which it occurs. For designated fair value hedges, both the hedging item and the underlying hedged item are measured at fair value. Changes in the fair value of both items are recognized immediately in net earnings on the Consolidated Statement of Earnings in the period in which they occur. The Company assesses, both at inception and over the term of the hedging relationship, whether the derivative contracts used in the hedging transactions are highly effective in offsetting changes in the fair value or cash flows of hedged items. If a derivative contract ceases to be effective or is terminated, hedge accounting is discontinued. Any gains (losses) relating to terminated cash flow hedges included in other comprehensive income are typically reclassified to net earnings on the Consolidated Statement of Earnings in the period in which the cash flow hedge is terminated. Note 2. CHANGES IN ACCOUNTING POLICIES The Company adopted Canadian Institute of Chartered Accountants (CICA) Handbook Section 1506, Accounting Changes; Section 1530, Comprehensive Income; Section 3855, Financial Instruments – Recognition and Measurement; Section 3861, Financial Instruments – Presentation and Disclosure; Section 3865, Hedges; and Emerging Issues Committee (EIC) Abstract 160, Stripping Costs Incurred in the Production Phase of a Mining Operation, on January 1, 2007. … 6 Note 5. INVESTMENT AND OTHER INCOME (EXPENSE) Investment and other income (expense) includes net losses related to the Buzzard derivative contracts (Note 23) of $535 million (2006 - $259 million’ 2005 - $889 million) and … Note 23. FINANCIAL INSTRUMENTS AND DERIVATIVES The Company is exposed to market risks resulting from fluctuations in commodity prices, foreign exchange rates and interest rates in the course of its normal business operations. The Company monitors its exposure to market fluctuations and may use derivative instruments to manage these risks, as it considers appropriate. The Company does not use derivative contracts for speculative purposes. Crude Oil and Products During 2004, the Company entered into a series of derivative contracts for the future sale of Dated Brent crude oil in connection with its acquisition of an interest in the Buzzard field in the U.K. sector of the North Sea. some derivative contracts matured from July 1, 2007 to December 31, 2007. All remaining outstanding derivative contracts were settled. This resulted in the following: 2007 Unrealized losses at beginning of year Net losses during current year (Note 5) Maturities1 Settlement2 1 2 $ (1,481) (535) 291 1,725 $ - Derivative contracts that matured from July 1, 2007 to December 31, 2007 resulted in realized losses of $291 million ($193 million after-tax). All remaining outstanding derivative contracts were settled, which resulted in realized losses of $1,725 million ($1,145 million after-tax). The Company enters into forward contracts and options to reduce exposure to Downstream margin fluctuations, including margins on fixed-price product sales, and short-term price fluctuations on the purchase of foreign and domestic crude oil and refined petroleum products. The Company’s outstanding derivative contracts and their related fair values at December 31, 2007 were as follows: Crude Oil and Products (millions of barrels) Crude oil purchase Crude oil sales Quantity (MMbbls) Maturity Average Price US$/bbl 0.8 0.8 2008 2008 $ 95.43 $ 95.72 Fair Value $ (1) $2 $1 The fair value positions of outstanding derivative contracts were included on the Consolidated Balance Sheet as follows: December 31, December 31 2007 2006 Accounts receivable $ 1 $ Accounts payable and accrued liabilities 233 Other liabilities 1,252 The fair value these derivative contracts is based on quotes provided by brokers, which represents an approximation of amounts that would be received or paid to counterparties to settle these instruments prior to maturity. The Company plans to hold all derivative contracts outstanding at December 31, 2007 to maturity. Derivative contracts and financial instruments involve a degree of credit risk. The company manages this risk through the establishment of credit policies and limits, which are applied in the selection of counterparties. Market risk relating to changes in value or settlement cost of the Company’s derivative contracts is essentially offset by gains or losses on the underlying transaction. In addition to the derivative contracts described above, the Consolidated Balance Sheet includes other items considered to be financial instruments, such as cash and cash equivalents, accounts receivable, accounts payable 7 and accrued liabilities, the Fort Hills purchase obligation and long-term debt. The fair values of these other financial instruments included on the Consolidated Balance Sheet are as follows: 2007 Carrying Amount Held-for-trading financial assets Cash and cash equivalents Loans and receivables: Accounts receivable1 Other long-term assets Other financial liabilities (not held-for-trading) Accounts payable and accrued liabilities Short-term notes payable Long-term debt Fort Hills purchase obligation 1 $ 231 2006 Fair Value $ 231 Carrying Amount $ 499 Fair Value $ 499 1,931 197 1,931 197 1,566 131 1,566 131 (3,512) (109) (3,341) (329) $ (4,932) (3,512) (109) (3,495) (329) $ (5,086) (3,319) (2,894) (170) $ (4,187) (3,319) (2,959) (170) $ (4,252) Accounts receivable on the Consolidated Balance Sheet as at December 31, 2007 include $42 million (December 31, 2006 - $34 million) of prepaid expenses. Excluding long-term debt, the fair value of financial instruments approximates their carrying amount due to their short maturity. The fair value of long-term debt is based on publicly quoted market values. Although there is no global convergence on a single correct standard for financial instruments, the Canadian standards are based on, but not identical to International Financial Reporting Standard 39 issued by the International Accounting Standards Board. The new section on financial instruments has necessitated changes to many other sections of the CICA Handbook.