Recognition & Measurement

IFRS 9 has replaced IAS 39 and has become effective with effect from 1st Jan 2018 in all geographical regions covered by IFRS Standards. Ind AS 109 which is the equivalent of IFRS 9 is effective with effect from 1st April 2016 for listed entities.

Contracts to deal with non-financial asset in foreign currency

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:

  1. the functional currency of any substantial party to that contract;
  2. 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.

Treatment of contracts dealing with non-financial assets

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.

Message / Review from CA P. R. Ramesh, Chairman, Deloitte Haskins & Sells LLP

CA P R RameshFinancial 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.

CA P. R. Ramesh,
Chairman,
Deloitte Haskins & Sells LLP,
Mumbai.Book cover

Foreword by Padma Shri T.N. Manoharan, Chairman, Canara Bank

T N ManoharanMr 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.

Sri T.N. Manoharan
Chairman, Canara Bank
Padma Shri Awardee
Former President of ICAI

Message from CA. Tarun Jamnadas Ghia

CA Tarun GhiaMy compliments to CA. R. Venkata Subramani in bringing out the book ‘Financial Instruments as per Ind AS’ and making a very sincere attempt to bring out the nuances on financial instruments, relevant to Ind AS. The concepts have been explained in a lucid language with ample illustrations. Hedge accounting is another area explained in simplified manner with relevant examples. The writings on new impairment methodology should also be quite useful to the readers to understand the concept with more clarity. All the best.

Book cover

 

Valuation of financial guarantee contracts as per Ind AS 109 – valuation services

What is a financial guarantee contract?

A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for loss it incurs because a specified debtor fails to make payment that is due in accordance with the original or modified terms of a debt instrument.

Accounting for financial guarantee contracts

If an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting that is applicable to insurance contracts, the issuer may elect to apply either Ind AS 109 or Ind AS 104 to such financial guarantee contracts. The entity may make that election on a contract by contract basis. How-ever, the election for each contract is not revocable.

Financial guarantee contracts after initial recognition is measured at the higher of:

  1. Impairment loss allowance determined as per requirements of Ind AS 109 and
  2. The amount initially recognised less cumulative amount of income recognised as per Ind AS 18.

Date of initial recognition

For financial guarantee contracts, the date the entity becomes a party to the irrevocable com-mitment is considered to be the date of initial recognition for the purpose of applying the im-pairment requirements.

Legal form

A financial guarantee contract may have different legal forms viz., guarantee, letter of credit, a credit default contract or an insurance contract. The accounting treatment for such financial guarantee contract is not dependent on its legal form.
Contracts that are not financial guarantee contracts

Some credit-related guarantees do not, as a precondition for payment, require that the holder is exposed to, and has incurred a loss on, the failure of the debtor to make payments on the guaranteed asset when due. An example of such a guarantee is one that requires payments in response to changes in a specified credit rating or credit index. Such guarantees are not financial guarantee contracts as defined in this Standard, and are not insurance contracts as defined in Ind AS 104. Such guarantees are derivatives and the issuer should apply Ind AS 109 for such contracts.

If a financial guarantee contract was issued in connection with the sale of goods, the issuer should apply Ind AS 18 in determining when it recognises the revenue from the guarantee and from the sale of goods.
If a financial guarantee contract was issued to an unrelated party in a standalone arm’s length transaction, its fair value at the inception is likely to be equal to the premium received.

Timing of recognising life time expected credit losses

For financial guarantee contracts, an entity should consider the changes in the risk that the specified debtor will default on the contract. The significance of a change in the credit risk since initial recognition depends on the risk of a default occurring as at initial recognition. Thus, a given change, in absolute terms, in the risk of a default occurring will be more significant for a financial instrument with a lower initial risk of a default occurring compared to a financial instrument with a higher initial risk of a default occurring.

The risk of a default occurring on financial instruments that have comparable credit risk is higher the longer the expected life of the instrument; for example, the risk of a default occurring on an AAA-rated bond with an expected life of 10 years is higher than that on an AAA-rated bond with an expected life of five years.

For a financial guarantee contract, the entity is required to make payments only in the event of a default by the debtor in accordance with the terms of the instrument that is guaranteed. Accordingly, cash shortfalls are the expected payments to reimburse the holder for a credit loss that it incurs less any amounts that the entity expects to receive from the holder, the debtor or any other party. If the asset is fully guaranteed, the estimation of cash shortfalls for a financial guarantee contract would be consistent with the estimations of cash shortfalls for the asset subject to the guarantee.

Period over which to estimate expected credit losses

For financial guarantee contracts, this is the maximum contractual period over which an entity has a present contractual obligation to extend credit.

Time value of money

Expected credit losses on financial guarantee contracts for which the effective interest rate cannot be determined shall be discounted by applying a discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows but only if, and to the extent that, the risks are taken into account by adjusting the discount rate instead of adjusting the cash shortfalls being discounted.

Impairment on transition to Ind AS

On transition, an entity should seek to approximate the credit risk on initial recognition by considering all reasonable and supportable information that is available without undue cost or effort. An entity is not required to undertake an exhaustive search for information when determining, at the date of transition, whether there have been significant increases in credit risk since initial recognition. If an entity is unable to make this determination without undue cost or effort an entity shall recognise a loss allowance at an amount equal to lifetime expected credit losses at each reporting date until that financial instrument is derecognised.

In order to determine the loss allowance on financial guarantee contracts to which the entity became a party to the contract prior to the date of initial application, both on transition and until the derecognition of those items an entity shall consider information that is relevant in determining or approximating the credit risk at initial recognition. In order to determine or approximate the initial credit risk, an entity may consider internal and external information, including portfolio information.

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Valuation of financial instruments as per Ind AS 109 – Valuation services

Ind AS 109 mandates financial instruments that are classified as fair value through profit or loss account to be fair valued whenever the financial statements are prepared. This ipso facto means that for all the listed entities, fair valuation of such financial instruments should be performed on a quarterly basis due to the listing requirements. Below is the partial list of financial instruments that should be valued on a fair value basis at every reporting period.

  1. Equity investments
  2. Debt securities (other than the ones classified as amortised cost)
  3. All derivative contracts including equity derivatives, interest rate derivatives, commodity derivatives, foreign exchange derivatives and credit derivatives
  4. Financial guarantee contracts
  5. Loan commitments
  6. Pre-payment features affecting the fair value of long term loans payable
  7. Interest in subsidiaries, associates and joint ventures which are not valued at cost
  8. Preference shares – convertible preference shares, cumulative preference shares, non-cumulative preference shares, compulsorily convertible cumulative preference shares, compulsorily convertible non-cumulative preference shares, preference shares with a put option and call option
  9. Long term security deposits – interest bearing security deposits, interest free security de-posits, interest bearing security deposits having fixed maturity, interest free security de-posits having fixed maturity
  10. Long term loans to subsidiaries, joint ventures and associates which are given at a con-cessional rate of interest or zero percentage
  11. Debentures – redeemable convertible debentures, redeemable non-convertible debentures, either with or without put and call options
  12. Term loans from banks where the transaction costs are written off in an earlier period

Contact: rvsbell@gmail.com; Mobile: +919444025255

Classification of financial assets

As per Ind AS 109, financial assets should be classified as one of the following:

  1. Amortised cost
  2. Fair value through other comprehensive income or
  3. Fair value through profit or loss

Classification is based on the analysis of the following two key factors:

  1. The entity’s business model for managing the financial assets and
  2. Contractual cash flow characteristics of the financial assets.

For an instrument that does not have a defined maturity period, the financial asset should be classified as either fair value through profit or loss or fair value through other comprehensive income.

For a debt security (since it has a pre-defined maturity period), all the three types of classification as mentioned above is possible viz., Amortised cost, Fair value through other comprehensive income or Fair value through profit or loss.
Key criteria to be examined for the purpose of classification of financial assets:

1) The entity’s business model: The business model of the entity should be analysed to find out if the financial asset is held with the objective to collect contractual cash flows that are solely payment of principal and interest or to collect such contractual cash flows as well as to buy or sell such financial asset. The business model objective should be analysed at the portfolio or sub-portfolio level and not on instrument-by- instrument basis. Such analysis should not be conducted at the entity level either, as the entity may have multiple business models to achieve different objectives for different sets of portfolios.

2) SPPI Criterion: The next key test to be performed is the test to find out if the contractual cash flows represent solely payment of principal and interest only. To understand the significance of this test, one need to have a very thorough knowledge of what is meant by both principal as well as interest. The standard specifies that principal is the fair value of the financial asset on initial recognition. Interest is primarily a consideration for the time value of money and includes the consideration for the credit risk associated with the financial asset. Interest also includes consideration for the other basic lending risks and costs including the profit margin.

If the financial asset is held with the business model objective to collect contractual cash flows that represent solely payment of principal and interest, then such a financial asset should be measured at amortised cost.

If the business model objective is to collect both the contractual cash flows as well as to buy and sell such financial assets, the financial asset should be classified as fair value through other comprehensive income, provided the contractual cash flows represent solely payment of principal and interest.

If the contractual cash flows do not represent solely payment of principal or interest or if the financial asset is held with the business model objective, i.e. neither to collect the contractual cash flows nor to buy or sell such financial assets, then the classification should be fair value through profit and loss account.

Derivative Instruments

Derivative Instrument

  • Derivatives are financial instruments
  • They derive their value from an underlying asset price or index
  • Their primary purpose is to create rights and obligations to facilitate the transfer of risks between the party wanting to transfer and the party with the risk appetite willing to take on the risk
  • Usually used as a hedging instrument for managing risks

Definition of a derivative

  • A derivative is a financial instrument or other contract with all three of the following characteristics:
  1. its value changes in response to the change in a ‘underlying’;
  2. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and
  3. it is settled at a future date

Examples of certain underlying

  • The following are some examples of underlying

– Interest Rate
– Security price
– Commodity price
– Index like Dow Jones, Sensex, Nifty
– FX rate
– Credit rating provided by an agency
– Non-financial variable like weather

Key features of derivative

  • Where the underlying is a non-financial variable, then it should not be specific to a party to be a derivative – else it would become an insurance contract
  • A derivative can have more than one underlying – for example a cross currency interest rate swap has a FX rate as one variable and interest rate as another variable

R. Venkata Subramani

Financial Instruments

Hedge Accounting

ECL / CECL

IFRS / US GAAP / Ind AS

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