Download Asset - Ludhiana

Financial Instruments: An
Overview
The Institute of Chartered Accountants of India
(Set up by an Act of Parliament)
What is a financial instrument ?
A contract that gives rise to:
in one entity
and
in another entity
Financial Instruments
Primary
 Equity instruments
 Bonds, loans,
borrowings
 Receivables /
payables (including
finance leases)
 Deposits of cash
Derivatives
Forwards / futures
Financial options
Swaps
Caps and collars
Financial
guarantees
 Letters of credit





Combinations




Convertible
debt
Exchangeable
debt
Dual currency
bonds
Equity linked
notes
Financial Asset

Cash and cash equivalents

Equity instrument of another entity

Contractual right to receive cash/ other Fin assets

Exchange fin assets/ fin liabilities under potentially favourable condition

Contract to be settled in entity’s own equity instruments
Financial Liability and Equity Instruments

Financial liability is a contractual obligation

to deliver cash or another financial asset or

to exchange fin.assets / fin. Liabilities (under potentially
unfavourable conditions)

A contract that will or may be settled in own equity instruments
(Own equity instruments do not include share warrants, share options etc..)

Equity instrument is any contract that evidences residual interest in the
assets of the entity after deducting all liabilities
Classification of Liability and Equity

Classification depends on substance

Even component parts in an instrument may have two different features,
say one part an equity and another part a liability

An entity should classify the instrument’s component parts separately.

Debt securities with an embedded conversion option, such as a convertible
bond, should be separated into the liability component and the equity
component on the balance sheet.
Equity or Debt

A Ltd issued convertible bonds of Rs 100 each, with 9% coupon rate,
which will be redeemed through conversion in to equity shares, any time
after two years at the option of the holder, at the market price ( as on date
of exercising the option). Holders also can opt for redemption in cash on
maturity ie after 5 years. What is the nature of the contract – debt equity
or combination

This is a debt . When redemption by conversion results in variable
number of shares ( that means not fixed number of shares as price of
conversion not fixed), it is a liability
Is contract to receive Gold Bullion a
Financial Instrument

Financial instrument has to have contractual right to receive cash or another
financial instrument.

Being Realizable or Liquid is not the test of financial instruments

Although bullion is highly liquid , it is not a financial instrument.
Are there any non financial items brought with in
the scope of IAS 39 and 32

Contracts entered for receipt or delivery of non-financial items in
accordance with the expected purchase /sale/usage requirements in the
ordinary course of business are not in the scope of IAS 39 and IAS 32

However those that are expected to be settled net in cash or in another
financial instrument or by exchanging financial instruments as if the
contracts were financial instruments, would fall with in IAS 39 and IAS 32
Whether Financial instrument




Whether an oral contract giving right to receive
cash is a Financial Instrument?
Whether bank deposit is a Financial Instrument?
Whether trade accounts receivable and payable,
loans and bonds receivable and payable are
Financial Instruments?
Whether Finance Lease is a Financial Instrument?
Contracts to buy or sell non Financial Items



Contract to purchase vegetables and fruits from
farmers.
Contract to purchase vegetable and fruits from
farmers and simultaneous contract to sell those
vegetables and fruits to Mandi.
Contract to purchase vegetable and fruits from
farmers providing that on expiry the differential
price will be paid by one party to the other.
Compound Financial Instruments

An entity issues 2000 convertible bonds as on
01/04/08 having a 3 yr. term, face value of
Rs.1000/- per bond & int. @6% p.a. each bond is
convertible at any time up to maturity into 250
ordinary shares. When the bonds are issued, the
prevailing market interest rate for similar debt
without conversion option is 9%. How should the
entity recognise the instrument?
Response
1
120000
0.92
110400
2
120000
0.84
100800
3
2120000
0.77
1632400
Fair Value of Bonds
1843600
Differential being fair value of equity
conversion feature
156400
Total Consideration received
2000000
13
Financial Asset
At fair value thru P&L
Held for
trading
FV to P/L
Held-to-maturity
Designated upon
initial recognition
FV to P/L
Loans and
receivables
Available-forsale
FV to Equity
Amortised
cost
Unquoted equity investment
should be stated at cost less
impairment (if fair value cannot
be measured reliably)
Financial liabilities
At fair value
thru P&L
Held for
trading
Designated
upon initial
recognition
That arise when a
transfer of a financial
asset does not qualify
for derecognition or is
accounted for using
the continuing
involvement approach
Others
When is an Asset classified as held for Trading

Acquired (incurred) principally for the purpose of sale (repurchase) in near
future

Part of a portfolio is managed together and there is evidence that there is a
recent actual pattern of short term profit booking.

A derivative (other than a designated and effective hedging instruments)
Trade pattern Vis a vis classification
-under HFT

A has a basket of corporate bonds that have different maturity periods.
Company’s policy is to explore opportunity for booking profits , whenever
there is any . Although the company has been able to trade in a few short
duration bonds during reporting period, many a number of bonds that had
long terms maturity were not sold during reporting period . Should the
whole portfolio be classified as HFT.

If there is evidence of a recent actual pattern of short term profit booking,
on certain items, included in that portfolio, the whole of the portfolio be
categorised as HFT
Item designated at F V thro’ P/L to remove
Accounting Mismatch

An investment banker raises funds through FMPs , that gives an assured
return plus bonus based on fair value returns plus interest dividend yields
from a select basket of investments . The liabilities are measured at
amortised cost and the assets , being held for trading are at fair value
through P/L. Auditors are of the view that the liabilities also shall be
classified ‘at fair value thro’ P/L’

IAS 39 allows classification of financial assets and liabilities as at Fair
value through P/L , up on initial recognition, if the classification
eliminates (or significantly reduces) accounting mismatch or
inconsistencies from measurement and recognition by using other bases.
This is an option and not compulsion.
Designated at FV thro P/L because a portfolio is assessed
and tracked regularly at fair value ?

A venture capitalist assesses its investment very regularly at its fair values
and reports to top management, although the interests in such investments
are long term . The assets are classified as “at fair value through P/L”.
Comment

Policy of evaluation of fair value at regular intervals , in view of their
nature of business suggest that it should be the part of their risk
management policy. The intent of such a policy is to take appropriate
positions depending on fair value movement of investments.

IAS 39 permits initial recognition “at fair value through P/L” If according
to a documented risk management policy of an entity a group of items are
evaluated and reported to key management at fair value basis.
Are equity instruments not to be
valued at FV t’P/L

Not necessarily always. Only those that are held for trading or classified
on initial recognition need to be valued at Fair value.

Unquoted equity instruments and whose fair value can not be reliably
measured, shall not be designated at fair value thro’ P/L
What falls under HTM

Has to be non derivative financial asset

With Fixed maturity date

With Determinable repayment amount

The entity has the positive intention to hold till maturity

Should not have been designated up on initial recognition as at fair value
through P/L

Should not have been designated under AFS

Should not have been falling under Loans and receivables
Exception to Tainting Rule

Premature Sale immediately prior to maturity where cash flow not affected
despite the premature sale.

Premature Sale , because of regulatory requirement or court orders

Premature closure because company is constrained for survival
HTM assets pledged / lent


If assets classified as HTM are (a) pledged (b) under repo agreements or ©
security lending agreement will it affect its classification
No, if intention to hold till maturity remains as same, classification will
remain HTM.
Consequences of HTM Tainting

Reclassify as AFS

If no sales from HTM in the current year and in two preceding years, then
classify back as HTM

On reclassification to AFS value at FV and charge to OCI

On reclassification back to HTM, the carrying FV becomes the amortised
cost
Identify HTM Items

Can equity instruments be classified as “HTM”
 No as there is no fixed term and determinable amount of repayment

Can a debt instrument with variable interest rate be HTM as repayable
amount is not fixed.
 Yes, it can be HTM

Can a perpetual debt instrument that offers regular interest service be
HTM
 No, as there is no maturity date
Can a Debt instrument with Put Option be under HTM

6 year 10% debentures with put option after 1 year were purchased, put
premium being 2%. Repayment amount varies up on exercising the option,
depending up on the time of exercise. Investing company has classified it
as HTM and valued at amortized cost . Instrument is quoted and traded.
Auditors are of the view that it has to be under loans and receivables.
Comment

Paying for a put option , contradicts the intention to hold till maturity. So it
can not be HTM.

When traded in an active market it can not be under loans and receivables .
So it has to be under AFS and be valued at Fair value.
Which all assets fall under
Loans and Receivables

Must be non derivative financial assets with fixed or determinable payments
and are not quoted in an active market.

They must not be the one held for trading or designated on initial recognition as
at carried at FV thro’ P/L

They must not be the one initially recognised as AFS items

They must not be the one for which the holder may not recover substantially all
of its initial investments.( not due to credit deterioration, but say due to
conversion option)

The issuer must have classified them as liabilities rather than equity
When is an Asset classified under AFS

Either when it is designated as available for sale (any time)

Or when it is not in any of the other three classifications
Is Reclassification allowed for
Financial Instruments

No reclassification in to or out of the fair value through P/L category, while
they are held or issued

In the case of HTM , for reasons of change of intention not to hold under HTM
any longer, shift to AFS. Difference in FV to OCI
Initial Measurement
Financial asset or financial liability
is initially recognised
at fair value
Financial assets/
liabilities at fair
value thru P&L
plus transaction costs
Transaction costs:
 on purchase are included
 that may be incurred on
disposal are excluded
 are directly attributable to
the acquisition/issue of the
financial asset/liability
Held-to-maturity
financial asset
Financial liabilities
other than “at FV
thru P/L
Loans and
receivables
Available for sale
financial assets
Is transaction price the fair value ?

Investments made in Money Market Notes with 4 months tenure and 5%
annual interest had a transaction price of Rs 99 .00 against face value Rs
100.00 . The discounted value based on cash flow would have been Rs.
98.50 based on present market interest rate.

The difference is not material here and hence needs to be ignored.
Therefore transaction price has to be taken as fair value (IAS 39 para AG
79) for initial recognition

Unless there is some other consideration involved in the transaction price,
fair value and transaction price have to be same on initial measurement
Interest free Loan to Staff

An interest free loan, say, Rs 1.20 L was given recoverable in 8 quarterly
installments . Rate of interest in market is, say, 10%. How would the loan
be initially recognized.

Fair value being the present value of future cash flows , from monthly
recoveries , when discounted at 10% is say 107550.00. Then the balance
Rs 12450 is employee benefit falling with in IAS 19.

In future periods it would be valued at amortised cost (which has to be the
PV of future cash flows discounted at 10% )
Terms of Loan varied from Market Rate

Rs 100 crores , Loan, repayable after 3 years, was raised at 7% interest
against the market rate of 9%. But a one time fee of 2% was to be
additionally paid in advance.

The fair value here ,ie, the net present value of cash flows discounted at
9% (both interest plus principal) is say Rs 97.75 crores.

Net cash flow on raising loan was also 98.00 Crs, ie the transaction value
here.

Here variance between the two is very insignificant .In a fair market
pricing variance is unlikely

Therefore the loan is recognized at 98.00 Crs deemed to be the fair value.
Subsequent Measurement
Financial assets are subsequently recognised
at amortised cost
Loans and
receivables
Held-to-maturity
investments
at fair value
At fair value thru
P&L
Unquoted equity
instrument and
related derivatives
Available-for-sale
securities
at cost
Calculation of amortised cost in a
Vanilla Contract

Suppose an amount of Rs 10.00 lakhs raised as debt with 7% annual
interest had expenses incurred were Rs. 50000.00 and a recovery of Rs
10000.00 was made towards application fee from lenders. Loan is
repayable after the end of 5 years

Here the cash flow involves Rs 9.60 L inflow on zero date, plus Rs
70000.00 out flow for each of the five years and Rs 10.00 L at the end of
the fifth year. The IRR is 8% here.

On the basis of effective interest rate 8% interest will be recognized each
year and liability at amortised cost will reflect in the balance sheet
Example : A Ltd. purchased 10% Debentures of face value Rs.
100 issued by B Ltd for Rs 99.5 on January 1, 2004. The
debentures will pay an annual coupon every 31 December and be
repaid after 5 years at 100.10. A LTd has incurred transaction
costs
of Rs.20.2 per debenture
.
1
3
4
5
Year
Cash Flow
(Rs.)
0
1
2
3
4
5
IRR
-99.7
10
10
10
10
110.1
10.10%
Effective
Interest
(Rs.)
10.07
10.07
10.08
10.09
10.09
Amortised
cost
99.70
99.77
99.84
99.92
100.01
100.10
Amortisation
effect
-0.07
-0.07
-0.08
-0.09
-0.09
Recognition on Trade Date or
Settlement Date Accounting

1000 bonds were bought on 28-3-2008 for Rs 120000.00 Fair value at year end
(on 31-3-08) Rs 121000.00 . Fair value on settlement date ( 2-4-08) Rs
123500.00

If trade date accounting followed asset is recognized on 28-3-2008 and fair
value change affects P/L on 31-3-08

If settlement date accounting is followed asset will be recognized only on 2-408, yet fair value change of Rs. 1000.00 shall be accounted on 31-3-08
1) Consolidate all subsidiaries (including any SPE)
Derecognition
2) Determine whether the derecognition principles below are applied
to a part or all of an asset (or group of similar assets)
Yes
3) Have the rights to the cash flows from the asset expired?
Derecognise
the asset
No
4) Has the entity transferred its contractual rights to
receive the cash flows from the asset?
No
Yes
5) Although contractual right to cash flow is retained,
has the entity assumed an obligation to pay the cash
flows from the asset to other recipients*
No
Continue to
recognise the asset
Yes
6) Has the entity transferred substantially all risks
and rewards?
Yes
Derecognise
the asset
Yes
Continue to
recognise the asset
No
7) Has the entity retained substantially all risks and
rewards?
No
8) Has the entity retained control of the asset?
Yes
Continue to recognise the asset to the extent of the
entity’s continuing involvement
No
Derecognise
the asset
Derecognition even when right to
Cash Flow retained by transferor

In an agreement to raise money against loan receivables from B Ltd, A Ltd
has retained the right to cash flow from those receivables, but assumed an
obligation to pay those cash flows to B Ltd without material delay.
Contract also says that A ltd has no obligation to pay those cash flows to
B Ltd unless collected, and that the asset will not be sold or pledged to any
one other than to B ltd as security. Should the asset be derecognized.

The terms above comply with Para 19 of IAS 39- conditions for treating a
transaction as “ transfer” . The conditions prima facie suggest that the
risks and rewards are substantially transferred

Asset has to be derecognised in that situation
Bill discounted with Full Recourse

Transfers the contractual right (to receive cash) to the bank

However, the company retains the risks (mainly credit risk) of the bills
receivable

May not meet derecognizing criteria under IAS 39

Present practice is to derecognize and show a contingent liability
Items beyond the Scope of IAS 39

Investments in JVs, Subsidiaries, associates

Leases

Employee Benefit related items

Insurance contracts

Share based payments

Contracts to results in future business combination

Right to Reimbursements

Certain loan commitments -only for recognition
Application of IAS 39 and 32 on Equity Instruments

For the holders of equity instruments , recognition and measurement
principles in IAS 39 as also presentation principles of IAS 32 are
applicable

For the issuers of equity instruments (including options and warrants) IAS
39 is not applicable.
Correctness of Fair Value

A has I million shares of B which is quoted at 105.00 on closing date.
Volumes traded in B scrip is too low as the shares are held by big
institutions. A obtained block deal quotes at 120.00 per share from several
prospective buyers. What is the right fair value 105 or 120

IAS 39 (AG 71 ) prescribes published price quotation in an active market
as the best estimate. So 105 has to be the FV

An unregulated market also can be active market. In case of more than one
market , most favorable price can be taken
Impairment of financial assets

Objective evidence of impairment from past events, must. Expected loss is
not recognized only incurred loss

Excess of carrying value over present value of cash flow (excluded future
credit losses )arrived at by using effective rate of interest is impairment
loss.

In the case of assets carried at cost, market rate of return for similar asset
can be the discount rate.

Assets carried at FV through P/L are not to be tested for impairment. Only
others need to be tested.

Impairment loss is charged to P/l and the asset is carried at net value
(either by writing down or by netting provision)
Derivatives and Hedging

Derivatives could be for Hedging or speculation

If not designated as effective hedging instruments, they shall be classified
at “fair value thro P/L” and the fair value changes will affect the P/L
account.

Those designated as hedge instruments also will be measured at fair value
for reporting purpose.

In case of cash flow hedges , such fair value changes can be accumulated
in equity, during the currency of hedge, subject to compliance of hedge
accounting norms.

In case of fair value hedge , P/L is charged with fair value changes of
hedge instruments
IAS 39 is being replaced with IFRS 9

IASB is undertaking a project to replace IAS 39 with IFRS 9 , to make it
simpler.

IFRS 9 is introduced in phases , the first of which has already been
published.

The first part deals with classification of financial assets .

Classification is based up on the business model

If a financial asset is held with an objective of collecting contractual cash
flows from interest and principal, it has to be measured at amortized cost.
In other cases , they are to be valued at fair value
Thank You
Manju Agrawal
FCA,DISA,CISA
Mobile : 9810555448