DISCUSSION ON ACCOUNTING FOR FINANCIAL INSTRUMENTS
Blog entries on accounting and disclosure requirements regarding various aspects of financial instruments as per Ind AS
Ind AS 21 deals with the effects of changes in exchange rates.
So, what are the issues that are involved here?
An entity may have foreign currency transactions and/or it may have foreign operations.
So, first we need to determine what is foreign currency.
Assume that an entity based in India purchases inventory from Denver in USD terms. The question arises as to in which currency the financial statements should be prepared. Should it be in INR or should it be in USD?
The financial statements should be prepared in the functional currency of the entity. This leads us to the next important question viz., what is meant by a functional currency. This is covered by Ind AS 21.
Next, an entity may have foreign operations, in the form of say a subsidiary or a joint venture. In that case, first we need to understand what is meant by a foreign operation and how should the functional currency be determined in respect of such foreign operations.
The next question arises as to whether the financial statements can be prepared in any currency which leads us to the next topic viz., what is meant by presentation currency?
Ind AS 21 covers all of these and in addition, it also gives guidance as to how the account balances should be translated into the functional currency, which exchange rate should be used and how the exchange differences should be accounted for.
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Where an entity is in the practice of entering into a derivative contract to either buy or sell a non-financial item in foreign currency, such contracts will also not be regarded as financial instruments. The entity should not be in the practice of dealing with such non-financial item merely with the intention to buy or sell in the short term with a view to making profits.
At the time of entering into contract to either buy or sell a non-financial item in foreign currency, there is also a foreign exchange component that is involved in such contracts. The question arises as to whether the FX component should be segregated and treated as an embedded derivative to be valued on a fair value basis.
The answer is provided in the accounting standard whereby it clearly mentions that the embedded portions in such contracts need not be segregated.
An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:
- the functional currency of any substantial party to that contract;
- the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or
- a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).
Hence, the forward contract dealing with a non-financial item in a foreign currency need not be fair valued.
A contract to deal with a non-financial asset is not a financial instrument. Commodity contracts normally result in either taking delivery or giving delivery of a non-financial item. Such contracts are not regarded as a financial instrument as per financial instruments accounting standard viz., Ind AS 109. However, if the contract is capable of being settled net in cash or any other financial asset, then such contract would be treated as though it is a financial instrument.
Exception to this principle
Contracts entered into with the sole purpose of either taking delivery or giving delivery of a non-financial item is not regarded as a financial instrument and is covered under the own-use exemption. However, there could be some derivative contracts dealing with non-financial items that may result in either delivery or providing delivery. If delivery or receipt of a non-financial item happens on account of a third party exercising an option (say put option), then the entity cannot claim exemption provided in ‘own-use exemption’. This happens especially when an entity enters into a written option contract to deal with a non-financial instrument. For example, if an entity writes a put option (sells a put option), then if the price of such non-financial asset drops below the put option strike price, then the buyer of such put option will exercise the option resulting in delivery of the non-financial item for the entity. In this case, even though the entity receives the non-financial item, it is not because of the entity’s choice to buy such a non-financial item but due to the third party exercising the put option resulting in delivery to the entity. Such contracts will be regarded as financial instruments and the entity should value such contracts on a mark to market basis.
If the entity avails ‘own-use exemption’ in respect of contracts that deal with non-financial items, such contracts need not be fair valued, as ultimately such contracts would result in either receipt or delivery of the non-financial item thereby directly impacting the cost of goods sold or consumed, as the case may be.
I have known R. Venkata Subramani for more than two decades now and he is known for his penchant for topics on financial instruments. He has dumped down the complex topic on the treatment of financial instruments as per Ind AS which I am sure is completely new for most of the professional accountants both in India and elsewhere. The timing of the release of the book coincides with the standards on financial instruments becoming applicable for the top corporate India including Banks and finance companies as per the road map issued by the MCA. I am sure this publication would be found quite useful for all professionals in their regular day-to-day official work, be it in practice or in Industry. My best wishes for the success of this publication.
CA P.B. Sampath
Director & Secretary
Tractors and Farm Equipments Limited
Financial Instruments is by far the most complex and difficult subject in the field of accounting. The varied nature of such instruments with a wide range of derivatives and associated risk makes the task of measuring and reporting extremely challenging even for experts in the subject. A number of books have been written on IFRS and more recently on Ind AS but very few books have dwelt at length on the subject of financial instruments.
This book by CA R. Venkata Subramani demystifies the subject of accounting for Financial Instruments and is extremely useful for practitioners, preparers, finance professionals and even for any person with basic knowledge of this subject. Written in a lucid manner with practical examples and screen shots of real data, it enables readers to very quickly grasp the principles and facilitates easy application of these principles. The inclusion of extracts from Annual Reports and FAQs enhances the utility of this book.
A book of this nature is very useful at a time when India has transitioned to Ind AS for certain large ‘public interest’ entities effective April 1, 2016 and the financial services sector too following soon.
I have no doubt this book will be a treasure for every professional and my compliments and best wishes to CA R. Venkata Subramani.
Mr R. Venkata Subramani, known for his expertise in the field of Financial Instruments accounting, has come up with a new edition of his book on Accounting for Financial Instruments as per Ind AS, incorporating all the relevant aspects in various chapters. The book lucidly deals with the various dimensions of presentation, classification, recognition, measurement and derecognition of Financial instruments in the initial chapters which would empower any reader with a conceptual understanding of the subject matter. The Book further explains in a lucid manner the impairment methodology in addition to elucidating on embedded derivatives and its reclassification.
The book adequately deals with Hedge accounting both in terms of Fair value dimension as well as cash flow dimension. Comprehensive coverage on Fair value measurement of financial instruments and effects of changes in forex rates should be immensely useful to those who refer to this book. Guidance is also provided on first time adoption of the accounting standards for financial instruments. There is cross reference provided to the guidance note on accounting for derivatives. The guidance note on accounting for derivatives and extracts from annual reports incorporated in the last two chapters should serve as ready reference to the users of book.
Mr.R.Venkata Subramani is a Chartered Accountant having immense knowledge and expertise on the matters dealt with in this book. The benefit of his hands-on experience and in depth practical exposure is reflected in the illustrations given in the various chapters of this book. Accounting standards notified as IND AS are Indian version of the IFRS with appropriate modifications. All the business organizations are expected to comply with the IND AS within the timelines prescribed. Considering the complex nature of accounting for financial instruments and in the light of compliance requirement of new set of standards notified by the Government as IND AS, the significance of this book cannot be undermined.
Banks, financial institutions, Insurance companies, Investment bankers, dealers, brokers, professionals and other investors would find this book quite useful in the day-to-day operations, as various concepts unique to the financial instruments are explained besides laying down the accounting treatment in a detailed manner. This book will be a useful addition to any library, which serves as a source of knowledge and information to all those associated with financial instruments accounting.
Description About the Book
The book covers financial instruments from the perspective of the issuer as well as the investor. It explains the concept of recognition, classification and subsequent measurement of financial assets and liabilities, de-recognition of financial assets and liabilities and impairment model. It also covers fair value and cash flow hedge accounting, disclosures required for financial instruments, fair value concepts and effects of fluctuations in foreign exchange. It includes lucid commentary on Financial Instruments as per Ind AS, discussing Ind AS 32, Ind AS 109, Ind AS 107, and some portions of Ind AS 113 and Ind AS 21. As we all know, Financial Instruments accounting is a new concept in India. The Indian Accounting Standards relating to financial instruments are quite complex and voluminous. The said standards (along with other 34 standards) are applicable from 1st April 2016 for Phase 1 companies, while the rest of the world would be adopting the equivalent standard IFRS 9 only from 1st Jan 2018. This book includes the basics of financial instruments and also dwells deep into the Indian Accounting Standards mentioned above with several practical case studies along with solutions for the same. Key Features Discussion based on Ind AS 32, 109, 107, 113 & 21 Elucidating topics with practical case studies Includes lucid explanation on hedge Accounting A guide to the certificate course in Ind AS (ICAI) and Dip in IFRS (ACCA, UK).
Almost all business transactions culminate in financial instruments in some form. In the present era of money, money and money, we witness an increasing trend of businesses being done through contractual arrangements which are structured to such an extent that after some time the contracting parties themselves struggle to understand the arrangement – intent vs agreement, substance vs form. Further, with commerce becoming global and development in any part of the globe affecting us, the movement of financial instruments is the first indicator of direction of impact. Derivatives market is growing, will take time to mature, more complex instruments are getting designed, markets’ depth is under test and they do impact valuation of both derivatives and the underlying. Financial reports should reflect the state of business and the business/ economic environment it is operating and hence all Financial Instruments have to be valued at the fair values on a continuous basis. Having said this, would like to highlight that this principle has been there in the Indian GaaP to date in the form of mark to market for forex receivables and payables, provisioning for receivables, mark to market of current investments and recognising shortfall, etc. The Financial Instruments standard is quite refined and has a matured approach where fair value is applied consistently and the gains/loss is recognised in “other comprehensive income” in most cases. The mark to market affects profit and loss statement only when there is an explicit choice or a conduct reflecting intent, to treat financial instruments as “fair value through profit and loss”. Also, there are many instruments which will continue to be carried at amortised cost (with right usage of effective interest rate) and do not require fair value determination.
The standard on Financial Instruments, has taken significant time to develop and even today there is no consensus on many aspects of the standard and unlikely in near future. A topic such as this, without a deep understanding of the financial markets is difficult to understand.
We in India, have a very peculiar situation of adopting a very complex standard like IFRS 9 (in the form of Ind AS 109), ahead of the rest of the world by 2-3 years. For companies who have voluntarily adopted Ind AS in FY15-16, the adoption has been done with transition date of 1st April 2014 vs. rest of the world who would follow from 1st Jan 2018.
In this backdrop, Venkat authoring a book is highly commendable and I thank him for the effort. Mr. R. Venkata Subramani (Venkat) has given adequate treatment of the subject with his hands-on experience on financial instruments as part of his previous assignments.
I have given a quick reading of the manuscript and compliment R. Venkata Subramani (Venkat) for the comprehensive coverage on Presentation, Recognition, Measurement and Disclosure aspects of financial instruments. Guidance is provided exhaustively on the new impairment methodology known commonly as ‘expected credit loss model’, which will be very relevant for banks and financial services companies. The book deals at length the complex topic on hedge accounting with several illustrations including guidance on basic journal entries for recording the same. The topics on fair value hedge and cash flow hedge are illustrated through a several examples. The book also covers the much needed first time adoption of Ind AS relating to financial instruments in particular. The Guidance Note on accounting for derivatives issued by ICAI is also covered quite well. The extracts from annual reports incorporated in the penultimate chapter should serve as ready reference to the professionals who implement Ind AS as it would give the precedence on several topics relating to financial instruments. To sum up, the book is a good teacher of the standards on financial instruments, a good reference book for practical application.
I advise readers of any authored text book to supplement with a reading of the text of the Ind AS, before applying the principles for professional purpose.
Happy reading. I wish Venkat the best and multiple editions of the book in years to come.
Financial Instruments has always been a dreaded topic for many and CA. R. Venkata Subramani has tamed the topic like no other. His explanation to the toughest of the topics is lucid enough to make it look easy. I was eagerly awaiting his book on financial instruments as per Ind AS since some time now. The book covers each topic exhaustively along with illustrations, journal entries and effects on profit and loss statement and balance sheet. Further, disclosures at the end of the chapter along with sample extracts of published accounts augment understanding of the standards. I would recommend this book to all professionals working/ aspiring to work in Ind AS domain.
CA Anand Banka,
Director, Financial Accounting and Advisory Services
S.R. Batliboi & Co. LLP Chartered Accountants
R. Venkata Subramani
ECL / CECL
IFRS / US GAAP / Ind AS
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