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Ifrs accounting for financial assets and financial liabilities
Financial Assets &Financial Liabilities
IAS 39 :Classification of Financial Assets• Financial Assets are classified into four categories – (i) Financial assets or liability at fair value through profit or loss,(ii) Held to maturity instruments ,(iii) Loans and receivables and(iv) Available for sale.
Financial Asset or Liability at Fair Value through Profit and Loss• It is classified as held for trading instrument. The following items are defined as held for trading – – financial asset or financial liability which are acquired or incurred principally for the purpose of selling or repurchasing in the near term, – part of the portfolio of identified financial instruments that are managed together , and for which there is evidence of recent short term and actual profit taking ; and – a derivative other than a financial guarantee contract or instruments which are designated as effective hedging instrument.• An entity designates this type of financial instruments as at fair value through profit or loss ( FVTPL) upon initial recognition .
Portfolio Balancing• Case Problem : A investment company holds a portfolio of debt and equity instruments. As per the investment strategy , it holds equity in the range of 50-60% , debt instruments in the range of 20-30% and cash holding is no less than 10% in any point of time and should be in the range 10 – 30%. Accordingly, the fund manager buy or sell equity and debt instruments from time to time for re-balancing the portfolio which of course results in short-term profit / loss. Can this act of portfolio re-balancing be termed as short-term profit taking ? Should the portfolio be classified as held for trading ?• Analysis : There can be different view point on this issue. It may be argued that it is risk management strategy. But this practice gives rise to short-term profit taking. If this practice is continuously followed the act of rebalancing should be definitely termed as short- term profit taking. It is necessary to evaluate past practice. Classification of the portfolio as held for trading will follow as a consequence.
Financial Asset or Liability at Fair Value through Profit and Loss….• An entity can classify financial instruments with one or more embedded derivative as FVTPL under Para 11A of IAS 39• A financial instrument may contain one or more embedded derivatives. The entire hybrid instrument may be classified as FVTPL• A financial instrument is also designated as FVTPL if such a designation results in more relevant information.
Relevant Information basis of designating FVTPL• Even if a financial asset or financial liability is not FVTPL as per the three criteria stated in the definition, it can be classified as FVTPL if either of the two conditions are fulfilled : – Elimination of accounting mismatch : That designation eliminates or significantly reduces the ‘accounting mismatch’. The term ‘ accounting mismatch signifies elimination or reduction of inconsistencies of measurement and recognition applying different bases ( like amortised cost ) and recognising gains or losses ( like recognising in other comprehensive income rather than in the income statement). – Risk Management approach : A group of financial assets or financial liabilities are managed together and performance evaluation is carried out on fair value basis. This practice has been documented in the risk management policy or investment strategy of the entity. This basis is also used for internal reporting to the key managerial personnel.
Financial liabilities designated as FVTPL• The following financial liabilities are classified as held for trading – – Liabilities for derivatives which are not hedging instruments; – Obligation to deliver financial asset by short seller which is borrowed ; – Financial liabilities that are incurred with an intention to repurchase them in near term ; – Financial liabilities which are portfolio which are managed together for short term profit taking.
FVTPL financial assets and financial liabilities• Refer to Table 3.1 of Chapter 3 of Accounting for Financial Instruments for AT A GLANCE view of the financial assets and financial liabilities that can be designated as FVTPL• Chapter 3 of Accounting for Financial Instruments for AT A GLANCE view of FVTPL classification for the purpose of portfolio balancing
Held To Maturity Investments• These are non – derivative financial assets with fixed or determinable payment and fixed maturity , and the entity has the positive intent and ability to hold them till maturity. Excluded from these are instruments which are designated upon initial recognition as FVTPL or available for sale or which meet the definition of loans and receivables• An equity instrument cannot be classified by the holder as held to maturity ( HTM) as it has no fixed maturity. But investment in redeemable preference shares , loans , debentures , etc. may be classified as HTM financial asset if other conditions are satisfied.
Conditions for HTM classification• An entity may classify a financial asset as held to maturity if it has the positive intention and ability to hold the asset till maturity.• The intention should be supported financial resources demonstrating ability to continue the investment till maturity. Also the existing legal and other constraints might affect the entity’s intention. The following circumstances does not substantiate positive intention to hold a financial asset till maturity : • if the entity intends to hold the asset for undefined period , it does not show the intention ; • if the entity intends to sell the asset in response to change in market price; • if the issuer has right to settle the instrument significantly below its amortised cost.
Amrotised cost• The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility.
Amortised cost…• It is internal rate of return ( IRR) of the cash flow of the financial instrument. Transaction costs (which are directly attributable to acquisition or issuance of the financial instruments are included in the cash flow. Similarly, premium / discount on issue or redemption are included in the cash flow. Effect of other contractual terms of the instrument like prepayment, embedded options are adjusted. However, normally no adjustment is carried out for possible credit loss. A deep discount bond often issued at price that takes care of interest as well as credit risk factor . For this type of instrument cash flow is not adjusted for credit risk factor while computing effective interest rate .
HTM Classification Example• [ Can puttable bonds be classified as HTM financial asset by the holder?] ABC Ltd. issues 10,00,000 9 % 10 year Rs. 100 bond purchased at 99.5. Bonds grants put option to the holder at the end 5 years at which point the holder can redeem them at Rs. 101 . These bonds are repayable at Rs. 102 at maturity.• XYZ Ltd. holds 10, 000 of these bonds issued by ABC Ltd. The holder wishes to classify this financial asset as held to maturity. Advice the company. How should the holder account for the financial asset ? Should the holder segregate the embedded put option ?•
Classification of Puttable Bond as HTM financial asset• As per Paragraph AG 19, IAS 39 , a puttbale bond cannot be classified as HTM financial assets. The holder has paid for put feature. It is inconsistent with the principle that the holder has the intention to hold the asset till maturity. Put option on the bond closely follows the same interest rate risk that the underlying financial asset is subjected to.• So embedded derivative is not required to be segregated. The holder can classify the financial asset as FVTPL or available for sale.
Classification of Callable bond as HTM financial assets• [ Can callable bonds be classified as held to maturity financial asset by the holder ? ] K Ltd. holds 1000 9 % 10 year Rs. 100 bond purchased at 99.5. Bonds grant call option to the issuer at the end 5th year when the issuer can redeem them at Rs. 100.50 . These bonds are repayable at Rs. 101 at maturity. K Ltd. has spent Re. 0.20 per bond on account of acquisition cost. K Ltd. wishes to classify this financial asset as held to maturity. Advice the company.
Classification of Callable bond as HTM financial assets• Callable bond can be classified as HTM by the holder – (i) if the holder intends and is able to hold it until it is called or until maturity; and (ii) the holder would recover substantially all of its carrying amount.• Exercise of the call option has the effect of accelerating the maturity. Ultimate test is ability of the holder to recover substantially all of its carrying amount by the call date. The holder has to include any premium paid and capitalised transaction costs in determining whether the carrying amount would be substantially recovered. The cost recovery issue is discussed further in Example 3.12.• The written call option on the bond closely follow the same interest rate risk that the underlying is subjected to. So embedded derivative is not required to be segregated. Refer Chapter 13 for a detailed discussion on embedded derivatives.
HTM Classification : Tainting Rule• An entity is not permitted at classify a financial instrument as held to maturity ( HTM) financial asset , if there is a past evidence of selling or re-classification of a significant portion of HTM assets . The past evidence is evaluated based on the data of the current year and immediately preceding two financial years.• Three exceptions to the tainting rule : • The entity sold HTM assets close to their maturity or call date such that no substantial price change was expected; • The entity sold HTM assets after it collected all substantial payment and prepayments; • Such selling or re-classification is attributable to isolated and non-recurring event beyond the control of the entity.
Relaxation of the Tainting Rule• Selling of a HTM financial asset in the following circumstances does not prohibit an entity from classifying a new financial asset as HTM : • HTM assets were sold because of significant deterioration of creditworthiness of the issuer ; • Change in tax law that eliminates or reduces tax exempt status of HTM assets; • Sale arising out of major business combination; • Change in statutory requirements; • Change in capital requirement for HTM assets; • Significant increase in risk weights.
Consequence of Selling HTM Assets falling within tainting rule• There is more stringent rule for the existing HTM financial assets of such an entity which sells more than significant amount of HTM financial assets during a financial year : i. It is required to re-classify all other HTM financial assets as available for sale ; ii. It cannot classify financial assets during next two years; and iii. For the purpose of consolidated financial statements, the same rule will apply to all members of the Group , an entity of Group has sold more than significant amount of HTM financial assets ( even if such entity is located in a different economic environment ).
Loans and receivables originated by the entity• They are non- derivative financial assets with a fixed or determinable payments and which are not quoted in an active market.• These items do not include which are originated with an intent to be sold immediately or in the short run - if so, they should classified as held for trading.• Similarly, financial assets which are initially recognised as available for sale are excluded from the definition of loans and receivables.• Also if the holder of the financial may not be able to recover all of its initial investment (other than credit deterioration) , it is classified as available for sale.
Loans and receivables originated by the entity…ABC Ltd. grants a loan of Rs. 110 million to XYZ Ltd. which the latter will payafter 2 years with 10% interest p.a. Analyse the following situations :Different Situations Classification1. ABC Ltd. intends to sell the loan in the near Held for trading term to P Ltd. at 9% yield. The loan clause permits the initiator to sale the loan to a third party.2. ABC Ltd. intends classify this loan at the Available for sale inception as available for sale3. ABC Ltd. intends classify this loan at the Held for Trading inception as fair value through profit and loss4. Other than three cases stated above Loans and receivables
Are unquoted redeemable preference shares loans and receivables to the holder?• X Ltd. purchases 10000 7% Rs. 100 preference shares of ABC Ltd. for Rs. 99.5 redeemable at Rs. 101 after 5 years. These preference shares are not quoted.• Can the holder classify the financial asset (Investment in redeemable preference shares) as loans and receivables?• Will the answer be different if the preference shares are quoted ?• What should be the accounting method if they are classified as loans and receivables?• Can they be classified as held to maturity asset?
Are unquoted redeemable preference shares loans and receivables to the holder?• Analysis : (i) By definition , loans and receivables are non-derivative financial assets with fixed or determinable maturity and that are not quoted in an active market. In case the holder does not wish to sell these preference shares in the near term , it can classify them as loans and receivables. These preferences shares satisfy the conditions stated in the definition of loans and receivables as per IAS 39 , therefore, can be classified as debt instrument in the hands of the issuer.• (ii) If they are quoted in an active market, they can not be classified as loans and receivables. In that case they are classified as available for sale.• (iii) Loans and receivables are measured at fair value at initial recognition. Any transaction cost ( directly attributable for purchase of preference shares) are added to the fair value. In subsequent measurement, amortised cost method ( applying effective interest rate) is followed.• (iv) They can be classified as held to maturity as well if the intention to hold these preference shares till maturity is satisfied. When these unquoted preference shares are held for undefined period , they should be classified as loans and receivables.
Can unquoted debentures be classified as loans and receivables in the hands of the holder?• X Ltd. purchases 10000 7% Rs. 100 Debentures of ABC Ltd. for Rs. 99.5 redeemable at Rs. 101 after 5 years. These debentures are unquoted. Can the holder classify the financial asset (Investment in unquoted debentures) as loans and receivables?• Analysis : Yes. The holder has , of course, the choice to classify them as available for sale. Even they can be classified as HTM if conditions are satisfied.
Available for sale financial assets• They are non- derivative financial assets other than those classified under any of the other three categories , i.e. they are not classified as – – financial asset at fair value through equity , – held to maturity, and – loans and receivables.
Measurement of Financial Instruments• The general principle of recognising a financial asset or a financial liability by an entity on its balance sheet : when, and only when it becomes a party to the contractual provisions of the instrument.• Measurement principles set out in Para 43 , IAS 39 are as follows : – (a) A financial asset or financial liability at fair value through profit or loss should be measured at fair value on the date of acquisition or issue. – (b) Short-term receivables and payables with no stated interest rate should be measured at original invoice amount if the effect of discounting is immaterial. – (c) Other financial assets or financial liabilities should be measured at fair value plus/ minus transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.• When settlement date accounting is followed in respect of a financial asset which is subsequently measured at cost or amortised cost , the asset is initially measured at fair value on the trade date.• Transaction price is normally the fair value of a financial instrument. It is the consideration given or received .
Accounting for transaction costs• Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of financial assets or financial liability. The term incremental costs signifies costs which would not have been incurred other than acquisition or disposal of financial instruments. Transactions costs comprise of – – fees and commissions paid to agents ( including fees and commissions to employees acting as agents ), advisers , brokers and dealers ; – levies by regulatory agencies and securities exchanges; – transfer taxes and duties .• Transaction costs do not include debt premium or discounts, financing costs or internal management expenses.• Premium or discounts on debt instrument is part of the fair value of the instrument.
Measurement Bases of Financial AssetsNature of Financial assets Initial recognition Subsequent measurementHeld for trading At fair value At fair valueFinancial assets classified as At fair value At fair valuefair value through profit and Directly attributable Gain or loss arising out of loss at initial recognition transaction cost is charged to change in fair value is chargedFVTPL profit and loss account profit and loss accountAvailable for sale At fair value plus directly At fair value attributable transaction cost Gain or loss arising out of change in fair value is charged directly to equity. When the asset is derecognised on sale or transfer, cumulative gain or loss arising out of change in fair value accounted for in equity is transferred to profit and loss account.
Measurement Bases of Financial Assets…Held to maturity At fair value plus At amortised cost directly attributable Change fair value is transaction cost not recognisedLoans and At fair value plus At amortised costreceivables directly attributable Change fair value is transaction cost not recognised
Accounting for Financial Assets• Refer to Examples 3.8-3.12 Chapter 3 Accounting for Financial Instruments ( forthcoming)
IFRS 9 Classification of Financial Assets• IFRS 9 classifies financial assets differently as compared to IAS 39. It does not have complicated principle of held to maturity accounting and tainting rule thereof.• Financial assets are:• (a) classified on the basis of the entity’s business model for managing the financial assets and the contractual cash flow characteristics of the financial asset.• (b) initially measured at fair value plus, in the case of a financial asset not at fair value through profit or loss, particular transaction costs.• (c) subsequently measured at amortised cost or fair value.
IFRS 9 Classification of Financial Assets• A financial asset is measured at amortised cost if both of the following conditions are met:• (a) the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.• (b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. [ Paragraph 4.2,IFRS 9].
IFRS 9 Classification of Financial Assets• The contractual cash flows would consist solely of payments of principal and interest on the principal amount outstanding ( as stated in Paragraph 4.2, IFRS 9) if they are consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time.• In case there is any other cash flows arising out of the asset or there is a limit on the cash flows in a manner inconsistent with payments representing principal and interest, the financial asset does not meet the condition stated in Paragraph 4.2(b) of IFRS 9.
Business Model• The business model followed by an entity is a critical factor for classification of financial assets. In particular , for classifying a financial asset at amortised cost it necessary to evaluate whether the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.
Business Model…• The business model is decided by the key managerial personnel ( refer to IAS 24 Related Party Disclosures for definition of the term). It is not an instrument specific model and therefore, intention of the management as regards a particular financial asset is not relevant. However, it is possible to have more than one business model.• So the business model is neither instrument –specific nor a broad concept to cover entity-wide model. It simply requires a higher level of aggregation. For example, it is possible to aggregate all loans to employees together to evaluate the business model.
Business Model…• An entity needs not hold a financial asset till maturity to satisfy the criteria that the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. An entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of some the financial assets occur. For example, the entity may sell a financial asset if:• (a) the financial asset no longer meets the entity’s investment policy (e.g. the credit rating of the asset declines below that required by the entity’s investment policy);• (b) an insurer adjusts its investment portfolio to reflect a change in expected duration (i.e. the expected timing of payouts); or• (c) an entity needs to fund capital expenditures.
Case Analysis 1 : Business Model• Entity E purchased 3% Debentures of € 20 million which form part of a portfolio of financial assets having contractual cash flows. It has adopted a business model whose objective is to hold assets in order to collect contractual cash flows. It evaluates among other information, the fair value of financial assets from a liquidity perspective (i.e. the cash amount that would be realised if the entity needs to sell assets). It also sold during the year certain items of financial assets having contractual cash flows out of the portfolio. Can the entity classify the new purchase as a financial asset at amortised cost?
Solution to Case Analysis 1 : Business Model• An entity’s business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur.• As per Paragraph B4.1.3 , IFRS 9 , infrequent sale out of the portfolio of financial assets having contractual cash flows does not alter the entity’s business objective. An entity may sell some of the financial assets which no longer meets the entity’s investment policy , or for adjusting the duration of the portfolio or to meet fund’s capital expenditure. It can classify the new purchase as financial asset at amortised cost.• However, it would re-assess the business model in the light of the objective of holding the assets for collecting contractual cash flows when there are more than infrequent number of sales.
Case Analysis 2 : Business Model• Entity E invested in corporate debentures. The portfolio may incur credit loss, However , the entity has adopted a business model whose objective is to hold assets in order to collect contractual cash flows. Can this loan portfolio be classified as financial asset at amortised cost ?
Solution to Case Analysis 2 : Business Model• The objective of the entity’s business model is to hold the financial assets and collect the contractual cash flows. It does not purchase the portfolio to make a profit by selling them. The same analysis would apply even if the entity does not expect to receive all of the contractual cash flows (e.g. some of the financial assets have incurred credit losses). So the loan portfolio can be classified as financial assets at amortised cost. [ Paragraph B4.1.4 , IFRS 9].• Applying the same principle , a portfolio of trade receivables may be classified as financial asset at amortised cost.
Nature of contractual Cash flows• To be classified as a financial asset at amortised cost , the contractual cash flows inherent in the financial asset shall consist solely of the payments of principal and interest on the principal amount outstanding for the currency in which the financial asset is denominated.
Case Analysis 1 : Contractual Cash Flows• Entity E invested in 5 year 4% € 1000 debentures. The debentures pay interest over 8 years and repay principal after 5 years. Are the debentures having contractual cash flows consisting solely of principal and interest on outstanding principal ?
Solution to Case Analysis 1 : Contractual Cash Flows• It is just readjustment of the timing of the cash flows. If the payment satisfies the condition of time value of money , it can be identified as contractual cash flows consisting solely of the principal and interest on outstanding principal. The entity would satisfy the condition comparing to benchmark yield of 5 year maturity debt instrument.
Case Analysis 2 : Contractual Cash Flows• Entity E invested in 1000 5 -year floating rate debentures of € 1000 each. However, the interest rate cannot be higher than 6.5%. Are the debentures having contractual cash flows consisting solely of the principal and interest on outstanding principal ?
Solution to Case Analysis 2 : Contractual Cash Flows• A variable rate debt instrument in which interest rate is capped satisfies the test of having contractual cash flows consisting solely of the principal and interest on outstanding principal. The contractual cash flows of both:• (a) an instrument that has a fixed interest rate and• (b) an instrument that has a variable interest rate• are payments of principal and interest on the principal amount outstanding as long as the interest reflects consideration for the time value of money and for the credit risk associated with the instrument during the term of the instrument.
Classification of Financial LiabilitiesFrom the perspective subsequent measurement, different types offinancial liabilities are-• Financial liabilities at fair value through profit and loss including stand alone derivative liabilities ;[ Stand-alone derivatives with negative values are classified as liability.All stand-alone derivatives are classified as FVTPL financial asset orfinancial liability].• Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies ;• Financial guarantee contracts;• Commitments to provide a loan at a below-market interest rate;• Liabilities at amortised cost.
Financial Liabilities…• At initial recognition all financial liabilities except FVTPL financial liabilities are measured at fair value minus directly attributable transaction costs. In case of FVTPL financial liabilities, directly attributable transaction costs are separately charged to the Statement of Profit and Loss.• At subsequent measurement all financial liabilities except (1)-(4) are measured at amortised cost.
Accounting for Repo Transaction• Refer to Example 4.3 of Chapter 4 Accounting for Financial Instruments ( forthcoming)
Loan Commitments• Certain loan commitments are with in the scope of IAS 39 :• (a) An entity that has a past practice of selling the assets resulting from its loan commitments shortly after origination shall applies IAS 39 to all its loan commitments in the same class.• The entity designates these loan commitments as financial liabilities at fair value through profit or loss.• (b) Certain loan commitments can be settled net in cash or by delivering or issuing another financial instrument. These loan commitments are derivatives.• A loan commitment is not regarded as settled net merely because the loan is paid out in instalments (for example, a mortgage construction loan that is paid out in instalments in line with the progress of construction).• (c) Commitments to provide a loan at a below-market interest rate. They are measured at the higher of:• (i) the amount determined in accordance with IAS 37; and• (ii) the amount initially recognised (see paragraph 43) less, when appropriate, cumulative amortisation recognised in accordance with IAS 18. [ Paragraph IAS 39.47(d) ]
Loan Reschedulement• Refer to Example 2.13 of Chapter 2 of Accounting for Financial Instruments
Guidance to Fair Value Measurement Issues Details1. Basic principle Fair value measurement is based on going concern presumption. The entity will not be able realise it in forced or distress sale.2. Active Market Quoted Price Active market does not necessarily mean stock exchange. Availability of regular and ready quotation for an financial asset from an exchange , industry group, pricing service or regulatory agency etc. means active market quoted price.Use of bid or ask price The appropriate quoted market price for an asset held or liability to be issuedMid-market price should be the current bid price. The appropriate quoted market price for anPrice of recently observed asset to be acquired or liability held should be the current ask price. If thetransaction entity has financial assets and liabilities with offsetting market risk , it can use mid-market price. In absence of current bid or ask price , the entity may use price of most recent transaction.Adjustment to last observed If the entity demonstrates that last observed price was not a fair marketprice quotation , e.g. it was a distress sale, it can make adjustment to last observed price. Also if there is change in conditions since the last transaction has taken place, there is a need for adjusting the fair value.Adjustment for credit risk This is of course adjusted by the entity for counterparty risk, country risk , etc. When the entity uses market yield for determining fair value of a debt instrument , it is necessary to consider whether such rate includes credit risk factor or not. If not, there is a need to adjust for credit risk.
Guidance to Fair Value Measurement..3. Meaning of fair Price agreed by a willing buyer and willing seller in an arm’s lengthvalue transaction.4. Non active i. Valuation technique includes – (a) recent price of amarket valuation comparable transaction , (b) discounted cash flow ( demonstratedtechnique in this chapter, (c ) application option price model . ii. A valuation technique would be expected to arrive at a realistic estimate of the fair value if (a) it reasonably reflects how the market could be expected to price the instrument and (b) the inputs to the valuation technique reasonably represent market expectations and measures of the risk-return factors inherent in the financial instrument. iii. A valuation technique should therefore (a) incorporates all factors that market participants would consider in arriving at a price and (b) is consistent with accepted economic methodologies for pricing financial instruments. iv. An entity should periodically calibrates the valuation with reference to recently observed price of comparable transaction. v. The transaction is the best evidence of the fair value at initial recognition.
Guidance to Fair Value Measurement..4. Non- active vi. In subsequent measurement , change in fair value should arise from theMarket factors which market participants would consider in setting price. valuationtechnique.. vii. If the financial instrument is a debt instrument (such as a loan), its fair value can be determined by reference to the market conditions that existed at its acquisition or origination date and current market conditions or interest rates currently charged by the entity or by others for similar debt instruments (i.e., similar remaining maturity, cash flow pattern, currency, credit risk, collateral and interest basis). vii. The entity may not have same information in all measurement date. viii. While applying discounted cash flow analysis, an entity uses one or more discount rates equal to the prevailing rates of return for financial instruments having substantially the same terms and characteristics, including the credit quality of the instrument, the remaining term over which the contractual interest rate is fixed, the remaining term to repayment of the principal and the currency in which payments are to be made. ix. Short-term receivables and payables with no stated interest rate are measured at the original invoice amount if the effect of discounting is immaterial.
Regular way purchase or sale contract• It is defined as a purchase or sale contract of financial asset whose terms require delivery of the asset within the time frame established generally by regulation or convention in the market place.• The contract is not limited to transactions in formal stock or derivative exchanges or over-the –counter exchanges. This definition refers to broad market wherein the financial assets are customarily exchanged.• So delivery should be within the time frame which is reasonable and customarily required for the parties to prepare and execute closing documents.• Sometimes an entity may deal in financial assets in different exchanges wherein there are different delivery rules. The entity should follow the delivery rule of the market in which the purchase or sale contract has been entered into.
Regular way purchase or sale contract..• A regular way purchase or sale contract is recognised using either trade date accounting or settlement date accounting.• On the trade date , the entity commits to purchase or sell the financial instrument whereas on the settlement date , the financial instrument is delivered to or by an entity.
Trade Date Accounting• Under trade date accounting , a financial asset purchased is recognised on the trade date along with simultaneous recognition of related liability to pay for it.• Similarly , financial asset sold is derecognised on the trade date with recognition of gain/loss on sale of that asset and related receivables.• If the financial asset is an interest bearing instrument like debt or bond, interest does not accrue on and from the trade date.
Settlement date accounting• Under settlement date accounting , a financial asset purchased is recognised on the settlement date along with simultaneous recognition of related liability to pay for it.• Similarly , financial asset sold is derecognised on the settlement date with recognition of gain/loss on sale of that asset and related receivables.
Application of trade date accounting for purchase of a financial asset• X Ltd. purchases a financial asset as on 29 March , 2008 for Rs. 10 million.• The fair value of the asset on 31 March , 2008 ( Year End) and 1 April , 2008 ( Settlement date) Rs. 10.5 million and Rs. 10.3 million respectively.• Accounting treatment of the transaction would depend upon classification of the financial asset.
Trade Date Accounting …Date Held to maturity Available for sale Assets at FVTPL investment carried assets re-measured re-measured at at amortised cost to fair value with fair value with changes in equity changes in P&L29 March ,2008Financial Asset Dr. 10 10 10 To Financial Liability 10 10 1031 March 2008Financial Asset Dr. 0.5 To P & L A/c 0.5Financial Asset Dr. 0.5To Fair Value Reserve A/c 0.52 April ,2008 0.2P& L A/c Dr. 0.2 To Financial AssetFair Value Reserve A/c Dr. 0.2 To Financial Asset 0.2
Settlement Date Accounting..Date Held to maturity Available for sale assets Assets at FVTPL re- investment carried at re-measured to fair measured at fair amortised cost value with changes value with in equity changes in P&L29 March ,2008 No entry on trade date No entry on trade date No entry on trade date31 March 2008 0.5Receivables Dr. 0.5 To P & L A/cReceivables Dr. 0.5To Fair Value Reserve A/c 0.52 April ,2008Financial Asset Dr. 10.0 To Financial Liability / Cash 10.0Financial Asset Dr. 10.3Fair Value Reserve A/c Dr. 0.2 To Financial Liability / Cash 10.0 To Receivables 0.5Financial Asset Dr. 10.3P&L A/c Dr. 0.2 To Financial Liability / Cash 10.0 To Receivables 0.5
Derivatives• Derivative Instrument is defined in Paragraph 9 of IAS 39 . A derivative contract is characterised by all the three features that - – (i) its value changes in response to the change in specific interest rate, financial instrument price , commodity price, foreign exchange rate, index of price or rates , credit rating or credit index or other variables ; however, in the case of a non-financial variable , the variable is not specific to a party to the contract; – (ii) it requires no initial investment or an initial net investment that is smaller as compared to other contract to have similar response to change in market factor ; and – (iii) it is settled in a future date.• Common examples of derivatives are – interest rate swap , currency swap, commodity swap , equity swap , credit swap , total return swap, purchased or written treasury bond option , purchased or written currency option, purchased or written commodity option, purchased or written stock option, interest rate futures linked to government bond, currency futures, commodity futures , stock futures, currency forward , commodity forward , equity forward , etc.
Common underlyings of derivative contracts Derivative contracts and underlyingsList of contracts Underlyings1. Stock index futures / Option Benchmark index for example Nifty2. Stock futures / options Particular equity share3. Interest rate swap Interest rate4. Currency swap / currency futures / Exchange rate of the currencies involved currency option / Currency forward5. Commodity swap / commodity futures / Commodity price Commodity option / Commodity forward6. Equity swap / forward Equity price7. Credit swap Credit rating / credit index8. Total return swap Fair value of the reference asset9. Interest rate futures / options / FRA Interest rate
Definition of DerivativesIssues1. An interest swap contract requires gross settlement of interest . Can it be classified as a derivative contract under IAS 39 ?Analysis : Net settlement is not a pre-condition of derivative2. If fixed leg of an interest rate swap is prepaid , does it remain a derivative contractdespite of high initial investment ?Analysis : Initial investment for prepaid fixed leg should be compared with spotinvestment required to get similar floating leg position.Present value of the prepaid fixed leg shall be lower than spot investment to get similarfloating rate exposure. So it will satisfy the initial investment test set out in Para 9 , IAS39. It is a derivative contract.3. If fixed leg of an interest rate swap is prepaid subsequently, does it remain aderivative contract despite of high initial investment ?Analysis : It is to be treated as termination of old swap and origination of a new swap.Payment made for the balance life of the contract is equivalent to taking floating rateposition in the underlying.If the present value of the prepaid fixed leg is lower than spot investment to get similarfloating rate exposure , then it will be classified as derivative contract.
Definition of Derivatives…Issues4. If floating leg of an interest rate swap is prepaid subsequently, does it remain a derivative contract despite of high initial investment ?Analysis : The first characteristic of a derivative contract that the value of theinstrument changes in response to an underlying is missing if floating leg is prepaid( identification of the underlying and response to value change is must). It no longer remains a derivative contract.5. Can two non-derivative contracts be aggregated to make it a derivative contract ?For example , can a fixed rate loan payable and a floating rate loan receivable beoffsetting ?Analysis : Answer is in affirmative subject to fulfilment of certain critical condition.6. Is out of the money option a derivative contract ?Analysis : This question arises out of the settlement issue. A feature ofderivative contract is that it is settled on a future date. Settlement includesexpiry without exercise. If an out of the money expires worthless that signifies asettlement.
Definition of Derivatives…Issues7. Is a foreign currency contract based on purchase / sales volume treated as a derivative contract?Analysis : Volume based foreign currency has two variables , it has no initial investment and it is settled on future date(s). So it is a derivative.Similarly, a basis swap contract has two variables.8. Is prepaid forward a derivative ?Analysis : Here issue is the initial investment. Prepaid amount should becompared with alternative investment to get the same degree of exposures.9. Should the initial Margin in future / option contracts be considered whileevaluation initial investment in a derivative contract ?Analysis : Margin is just a collateral not an investment.
Swap Transaction X Ltd. has entered a 5 year Pay Fixed Receive variable swap contract with a swap dealer for a notional amount of Rs. 10 million. The swap rate is 6.5% p.a.. But the contract requires that X would pay gross at fixed rate every Jan 1 and July 1 and receive gross at floating rate .Does this swap contract satisfy the definition of derivatives ?Analysis : Yes. (i) value of the instrument changes in response to an underlying (identification of the underlying and response to value change is must) , (ii) no initialinvestment or smaller initial investment if similar value changes to be achieved throughthe underlying and (iii) settlement at a future date. In view of these three criteria theinterest rate swap contract (IRS) shall be evaluated. Para 9 , IAS 39 does put grosssettlement under a derivative as disqualification.
Prepaid interest rate swap• Prepaid fixed leg at the inception of the contract : In an interest rate swap there are two legs – fixed leg and floating leg. One party pays fixed rate in exchange the counterparty pays variable , say 6-month LIBOR. X Ltd. enters into a pay 8% fixed receive floating swap for 4 years on notional principal of Rs. 100 million . Settlement date is every Jan 2 and July 2. If X Ltd. pays the present value of the fixed leg discounted at the current market yield of 8% , the fixed leg of the swap is prepaid at the inception. Should the contract still be considered as a derivative ?• Analysis : Here the appropriate test is based on no initial investment or comparatively smaller initial investment in view of large amount of initial investment : ‘ it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors’.• As an alternative X Ltd. could invest Rs. 100 million in LIBOR denominated bond which would pay it 6- month LIBOR.• Prepaid fixed leg = Rs. 4 million half – yearly annuity factor for 4 years = Rs. 4 million 6.7327 = Rs. 26.93 million• X Ltd. could get the same amount based on 6 – month LIBOR investing Rs. 26.93 million rather than Rs. 100 million. So the transaction satisfies the requirement of comparatively smaller initial investment. It is a derivative contract under Para 9 of IAS 39.
Prepaid fixed leg subsequent to the inception of the contract• It means cancellation of the old contract. Suppose X Ltd. prepays the fixed leg after third six months . Then it pays for 5 fixed instalments. If the current market yield is 8.5%, then the prepaid fixed leg is - Rs. 4 million half – yearly annuity factor for 2.5 years = Rs. 4 million 4.4833 = Rs. 17.93 million• This is an one time payment ( representing a financial asset ) to get PV of 5 instalment of expected 6-month LIBOR on Rs. 100 million.• The new contract will remain as a derivative as that satisfies lower initial investment condition. Refer to IAS 39 IG B.4 which states that the new contract should be evaluated afresh.
Accounting For Option• X Ltd. purchased 1 lot of Reliance Call option, expiry 30 July 2009, market lot 300, stock price Rs. 2348 , Strike 2340 at 242.• As on 30 June the above-mentioned option is valued at 285 because stock price increased to Rs. 2500.• Show accounting entries.On 12.6.2009 Reliance Call Option Dr. 72,600 To Cash 72,600On 30.6.2009Reliance Call Option Dr. 12,900 To Fair Value Gain 12,900Fair Value Gain Dr. 12,900To Income Statement 12,900
Accounting For Futures• X Ltd. purchased 1 lot of Reliance Futures, expiry 30 July 2009, market lot 300, stock price Rs. 2348 , Future price 2368.• As on 30 June the above-mentioned futures is valued at 2565 because stock price increased to Rs. 2500.• Show accounting entries.On 12.6.2009 No entryFair Value of the futures on the transaction is zero.On 30.6.2009Reliance Futures Dr. 59100 To Fair Value Gain 59100Fair Value Gain Dr. 59100To Income Statement 59,100
Accounting for Currency ForwardForecast transaction subsequently resulting in recognised non-financial asset X Ltd. wishes to purchase inventory amounting to US$ 10 million on 30.6.2012 . Having apprehension of INR depreciation it has purchased 9 months US$ forward from its banker at 49.10 on October 1,2011 when spot rate was 47.50.Date US$/INR Spot Rate Type of forward Forward rate to 30.6.2012October 1, 2011 47.50 9 months forward 49.10Dec 31, 2011 47.30 6 months forward 48.80March 31,2012 50.20 3 months forward 51.00June 30,2012 55.00
Accounting for Currency Forward..• The company designated forward contract as hedging instrument in a cash flow hedge of foreign exchange contract to buy inventory.• How should the fair value of forward be computed ? What should be the accounting entries? Assume applicable yield in the local currency is 8% p.a.
AccountingDate Particulars Amount ( Dr.) Amount ( Cr.) Rs. in million Rs. in millionOct 1 2011 No entry required when forward contract is entered intoDec. 31 2011 Cash Flow Hedge Reserve Dr. 2.89 To Forward Liability 2.89 Fair value change of the forward contractMarch 31 Forward liability Dr. 2.892012 Forward Asset Dr. 18.63 Cash Flow Hedge Reserve 21.52June 30 Forward Asset Dr 40.362012 To Cash Flow Hedge Reserve 40.36 Gain on forward contract between 1.4.2012 to 30.6.2012June 30 Purchases 550.002012 To Cash 491.00 To Forward Asset 59.00June 30 Cash Flow Hedge Reserve Dr. 59.002012 To Purchase 59.00