Financial Instruments: An Overview The Institute of Chartered Accountants of India (Set up by an Act of Parliament)

Financial Instruments: An Overview

The Institute of Chartered Accountants of India (Set up by an Act of Parliament)

A contract that gives rise to:

and

in one entity

in another entity

What is a financial instrument ?

Combinations

Convertible debt

Exchangeable debt

Dual currency bonds

Equity linked notes

Derivatives

Forwards / futures

Financial options

Swaps Caps and collars Financial

guarantees Letters of credit

Primary

Equity instruments

Bonds, loans, borrowings

Receivables / payables (including finance leases)

Deposits of cash

Financial InstrumentsFinancial Instruments

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 aFinancial 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

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Financial AssetFinancial Asset

At fair value thru P&LAt fair value thru P&L

Available-for-saleAvailable-for-sale

Held-to-maturityHeld-to-maturity

Loans and receivablesLoans and receivables

Designated upon initial recognition

Designated upon initial recognition

Held for tradingHeld for trading

FV to P/L FV to P/L

FV to Equity

Amortised cost

Unquoted equity investment should be stated at cost less impairment (if fair value cannot be measured reliably)

Unquoted equity investment should be stated at cost less impairment (if fair value cannot be measured reliably)

Financial liabilitiesFinancial liabilities

At fair value

thru P&L

At fair value

thru P&LOthersOthersThat arise when a

transfer of a financial

asset does not qualify

for derecognition or is

accounted for using

the continuing

involvement approach

That arise when a

transfer of a financial

asset does not qualify

for derecognition or is

accounted for using

the continuing

involvement approach

Designated upon initial recognition

Designated upon initial recognition

Held for tradingHeld for trading

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 removeAccounting 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 valueFinancial assets/ liabilities at fair value thru P&L

Held-to-maturity financial asset

Financial liabilities other than “at FV thru P/L

Loans and receivables

Available for sale financial assets

plus transaction costsplus transaction costsTransaction 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

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 MeasurementFinancial assets are subsequently recognised

at amortised cost

Loans and Loans and receivablesreceivables

Held-to-maturity Held-to-maturity investmentsinvestments

at fair value

Available-for-sale Available-for-sale securitiessecurities

at costat costUnquoted equity Unquoted equity instrument and instrument and related derivativesrelated derivatives

At fair value thru At fair value thru P&LP&L

Calculation of amortised cost in aVanilla 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. 0.2 per debenture .

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3 4 5

Year Cash Flow

(Rs.)

Effective Interest (Rs.)

Amortised cost

Amortisation effect

0 -99.7 99.701 10 10.07 99.77 -0.072 10 10.07 99.84 -0.073 10 10.08 99.92 -0.084 10 10.09 100.01 -0.095 110.1 10.09 100.10 -0.09

IRR 10.10%

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 2-4-08, yet fair value change of Rs. 1000.00 shall be accounted on 31-3-08

2) Determine whether the derecognition principles below are applied to a part or all of an asset (or group of similar assets)

1) Consolidate all subsidiaries (including any SPE)

Continue to recognise the asset to the extent of the entity’s continuing involvement

4) Has the entity transferred its contractual rights to receive the cash flows from the asset?

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*

6) Has the entity transferred substantially all risks and rewards?

7) Has the entity retained substantially all risks and rewards?

8) Has the entity retained control of the asset?

Continue to recognise the asset

Derecognise the asset

Continue to recognise the asset

Derecognise the asset

No

Yes

Yes

No

Yes

No

Yes

No

No

Yes

3) Have the rights to the cash flows from the asset expired?

No

Yes Derecognise the asset

Derecognition

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