Financial Liabilities – Fair Value Option

Financial liabilities that are non-derivatives are normally valued at amortised cost.  Effective interest rate is computed for financial liabilities and based on that the interest expense is recognised on a periodical basis.  Transaction costs to source the liability are reduced from the financial liability for the purpose of calculating the effective interest rate.

An entity can, however, value a financial liability at fair value provided it eliminates or significantly reduces an accounting mismatch.  When an entity avails this option, then the financial liability is valued at fair value.  The difference between the carrying value and the fair value is recognised in the profit and loss account.

Let us assume that an entity issues a debt instrument for Rs.100 crores.  Let us also assume that the debt carries an interest rate of 8% per annum.  The debt being a non-derivative financial liability should be categorised as amortised cost liability and valued at amortised cost at every reporting period.  Let us also assume that at the time of issue, the bench mark interest rate was 6% and the credit risk premium amounts to 2% based on the credit rating of the entity.

If the entity exercises the option to classify the financial liability by availing the ‘Fair Value Option’ (FVO) option, then the liability will be valued at fair value on every valuation date.  If the liability is to be valued on a fair value basis, then it is necessary to find out the appropriate rate at which the liability and associated cash flows should be discounted to arrive at the fair value.  Let us assume that the bench mark interest rate becomes 7% at the end of the year and the credit rating remains the same.  The financial liability will be valued based on 9% (7% towards bench mark interest plus 2% towards credit risk premium) to arrive at the fair value of the liability.  Let us assume that the fair value of the liability at the end of the year based on 9% is Rs.97 crores.  This means that the carrying value of the liability would be written down from Rs. 100 crores to Rs. 97 crores resulting in a profit of Rs. 3 crores.  The entity will pass the following entry to record the fair value of the financial liability:

Increase in Credit Risk

Let us assume that the bench mark interest rate remains the same viz., 6% at the end of the year.  The entity incurs losses in the next 4 quarters and is perceived by the market as a risky enterprise. The credit rating of the entity goes down and the credit risk premium increases from 2% to 4%.  Now the financial liability will be discounted at 10% (6% towards bench mark interest rate plus 4% towards credit risk premium).  Let us assume discounting the cash flows based on 10% results of the financial liability being valued at Rs. 95 crores.  The entity will then record a further profit of Rs.2 crores towards the fair value changes of the financial liability. The entity will pass the following entry:

Here the entity earns a profit of Rs.5 crores without having to do anything.  In fact, the entity is now worse off than it was at the beginning of the year since the credit rating has gone down.  In spite of this, the entity makes a profit of Rs.5 crores.  This looks a bit weird and is counterintuitive, as this ipso facto means that the entity becomes more profitable if it becomes more risky.  The accounting standard has duly recognised this anomaly and has appropriately plugged the loop hole.  Now as per Ind AS 109, the fair value changes on account of credit risk is recognised in the other comprehensive income (OCI) while the fair value changes on account of changes in the bench mark interest rate is recognised in the profit and loss account.