Financial Instruments: Application issues under Ind AS · another financial instrument/by exchanging financial instruments, or is the non-financial item readily convertible into cash?

Financial Instruments: Application issues under Ind AS

March 2017

KPMG.com/in

About the publicationAs we approach the end of the first financial year since Indian Accounting Standards (Ind AS) became applicable, Indian companies in the first phase of convergence will soon be required to prepare their first annual financial statements in compliance with Ind AS.

Due to the pervasiveness and distinct nature of accounting for financial instruments, our research demonstrates that almost all companies that have presented their quarterly results upon transition to Ind AS have disclosed adjustments relating to financial instruments.

The Ind AS framework notified by the Ministry of Corporate Affairs (MCA) in 2015 includes three standards on financial instruments, Ind AS 109, Financial Instruments, Ind AS 32, Financial Instruments: Presentation, and Ind AS 107, Financial Instruments: Disclosures. The guidance provided in these standards is extensive and often complex in nature, requiring significant interpretation and exercise of judgement. The principles of Ind AS 109 are based on International Financial Reporting Standard (IFRS) 9, Financial Instruments, which becomes applicable internationally from 1 January 2018 onwards. As a result Indian companies face significant practical implementation issues due to the absence of precedents arising from international application.

While companies have applied the recognition and measurement requirements of these standards over the past three quarters, the annual financial statements will pose new challenges due to the extensive and onerous disclosure requirements in Ind AS 107. Compilation of these disclosures may require access to detailed information which may sometimes be difficult to obtain in the absence of changes to information systems for capturing relevant data.

This publication highlights many of the practical issues that Indian companies may face when implementing the guidance on financial instruments under Ind AS. It elucidates the relevant accounting principles in a clear and concise manner, with the help of flowcharts and worked examples that illustrate the application of key concepts and the related accounting impact on the balance sheet and statement of profit and loss. It is based on the Ind AS notified by MCA, including amendments up to 1 March 2017.

Perspectives on accounting for financial instruments

Need for judgementThis publication intends to highlight some of the practical application issues with the help of certain facts and circumstances detailed in the examples used. In practice, transactions or arrangements involving financial instruments are likely to be complex. Therefore, further interpretation and significant use of judgement may be required in order for an entity to apply Ind AS to its own facts, circumstances and individual transactions. Further, some information contained in this publication may change as practice and implementation guidance continue to develop. Users are advised to read this publication in conjunction with the actual text of the standards and implementation guidance issued, and to consult their professional advisors before concluding on accounting treatments for their own transactions.

References References to relevant guidance and abbreviations, when used, are defined within the text of the publication.

ContentsScope and definitions 01

09

17

29

Derivatives

Equity and financial liability classification

Recognition and derecognition

• Contracts for purchase or sale of non-financial items

• Accounting for financial guarantee contracts

• Foreign currency embedded derivatives

• Put options written on non-controlling interests

• Classification of convertible preference shares

• Preference shares convertible into a variable number of shares

• Impact of contingent settlement provisions on classification of financial instruments

• Accounting for long-term deposits and advances

• Derecognition of trade receivables under a factoring arrangement

• Derecognition of a financial liability

• Extinguishment of a financial liability with an equity instrument

• Accounting for low interest and interest free loans

© 2017 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

53

71

79

93

Classification and measurement

Impairment of financial assets

Hedge accounting

Financial instruments: Disclosures

• Classification of investments in preference shares

• Classification of investments in mutual funds

• Analysis of business model to determine classification of financial assets

• Application of effective interest method

• Impairment assessment for trade receivables

• Hedging foreign currency risk on forecast transactions

• Hedge accounting using cross currency interest rate swaps

• Frequently Asked Questions (FAQs) on disclosure of financial instruments


Scope and definitions


Contracts for purchase or sale of non-financial items

Ind AS 109, Financial Instruments applies to contracts to buy or sell non-financial items that:

• Can be settled net in cash; and

• Are not entered into, or continue to be held, for the purpose of receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

Contracts that meet the criteria above are considered to be derivative instruments under Ind AS 109 and those that do not, are considered executory contracts that are outside the scope of Ind AS 109. This case study highlights the relevant guidance and illustrates its application to a group of contracts.

Contract 1 Contract 2 Contract 3

Nature of contract

Import of oil seeds from a foreign supplier

Purchase of oil seeds from a domestic producer/supplier

Contract to sell oil seeds on the commodity exchange

Quantity and rate

100 MT at USD400 per MT to be delivered as on 31 March 2017

50 MT at INR30,000 per MT to be delivered as on 31 January 2017

50 MT at USD450 per MT, maturing as on 15 January 2017

Net settlement clause included in the contract

Yes Yes Yes

Net settlement in practice for similar contracts

Yes – company Z has net settled some of these contracts in the past. There have also been several instances of the oil seeds being sold prior to or shortly after taking delivery. These instances of net settlement constitute approximately 30 per cent of the value of total import contracts.

Yes – company Z has net settled some of the domestic purchase contracts. However, these instances constitute only 1 per cent of the total domestic purchase contracts in value. The remaining contracts are settled by taking delivery of the oil seeds which are used for further processing.

Yes – these contracts are required to be net settled with the exchange on the maturity date.

Company Z enters into these type of derivative contracts to hedge the risks on its domestic oil seeds purchase contracts.

Key terms of contracts to buy/sell non-financial itemsCompany Z is engaged in the business of importing oil seeds for further processing as well as trading purposes. It enters into the following types of contracts as on 1 October 2016:

Accounting issueCompany Z is required to determine if the contracts entered into for purchase and sale of oil seeds are derivatives within the scope of Ind AS 109 or are executory contracts outside the scope of Ind AS 109.


Financial Instruments: Application issues under Ind AS 2

Accounting guidanceFigure 1 illustrates the guidance in Ind AS 109 on analysis of contracts to purchase or sell non-financial items:

Source: KPMG in India’s analysis, 2017 read with Insights into IFRS, KPMG IFRG Ltd’s publication, 13th edition September 2016

Figure 1: Guidance on contracts to purchase or sell non-financial items

Can the contract be settled net in cash/another financial instrument/by exchanging financial instruments, or is the non-financial item readily convertible into cash?

Is the contract entered into and held in accordance with the entity’s expected purchase, sale or usage requirements?

Does the entity have a past practice for similar contracts of:• net settlement, or• taking delivery and selling within a short period of time

Yes

Yes

Yes

Yes

No

No

No

No

FVTPL

Executory contract

Has the entity elected to apply the ‘fair value option’ if FVTPL accounting would eliminate or significantly reduce an accounting mismatch?

Ind AS 109 is applicable to those contracts that can be settled net in cash or another financial instrument, including if the non-financial item is readily convertible into cash. However, contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with an entity’s expected purchase, sale or usage requirements are not included in the scope of Ind AS 109 (this is the ‘normal sales and purchases’ or ‘own-use’ exemption).

If the entity has a past practice of net settlement for similar contracts, such contracts would not be considered to meet the ‘own-use’ exemption.

Contracts that meet the ‘own-use’ exemption and are excluded from the scope of Ind AS 109 may give rise to accounting mismatches. For example, an entity may enter into derivative contracts to hedge the risks arising from such executory contracts and may be monitoring their net exposure on a fair value basis. The derivatives would be measured at fair value through profit or loss (FVTPL) whereas the executory contracts would not be recognised in the financial statements, leading to an accounting mismatch. Ind AS 109 therefore permits an entity to irrevocably designate such contracts as FVTPL even if they meet the ‘own-use’ exemption.

Analysis

Contract 1The following factors indicate that this contract does not meet the ‘own-use’ exemption:

• The contract permits net settlement, and

• There is a past practice of a significant proportion (30 per cent in this illustration) of similar contracts being settled on a net basis either in cash or by sale of the oil seeds prior to delivery/shortly after taking delivery.

Therefore, this contract would fall within the scope of Ind AS 109 and should be recognised as a derivative instrument as on 1 October 2016.

3 Financial Instruments: Application issues under Ind AS


The contract would be in the nature of a forward contract to buy 100 MT of oil seeds as on 31 March 2017 at USD400 per MT. Company Z would have to recognise the fair value changes (based on change in forward purchase rate) on this contract in the statement of profit and loss at each reporting date.

Contract 2Contract 2 also permits net settlement in cash. Further, there have been some instances of similar domestic purchase contracts being settled net in cash in the past. However, these have been infrequent in nature and insignificant in proportion to the total value of similar contracts (i.e. 1 per cent in this illustration). Company Z is in the practice of taking delivery of the oil seeds purchased under similar contracts and using them for further processing in its plants.

This indicates that the domestic purchase contract meets the criteria for the ‘own-use’ exemption and should be considered as an executory contract. Therefore, this contract would not fall within the scope of Ind AS 109.

Contract 3This contract is in the nature of a derivative contract transacted on a commodity exchange and is required to be net settled in cash on maturity. Therefore, this derivative contract would be covered by Ind AS 109 and required to be classified and measured at FVTPL.

Fair value optionThe derivative contracts (similar to contract 3) are transacted to hedge the risks on the domestic purchase contracts. While the derivatives are required to be measured at FVTPL, the domestic purchase contracts meet the ‘own-use’ exemption and are considered as executory contracts. These are typically not recognised until physical delivery of the oil seeds (depending on the terms of purchase). This gives rise to an accounting mismatch in the statement of profit and loss.

Ind AS 109 permits a contract to buy or sell a non-financial item that can be settled net in cash/another financial instrument to be irrevocably designated at inception as measured at FVTPL even if it was entered into for the purpose of

receipt or delivery of the non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (i.e. meets the ‘own-use’ exemption). This option (known as the ‘fair value option’) is available only if it eliminates or significantly reduces an accounting mismatch that would otherwise arise.

Consequently, company Z may opt to irrevocably designate contract 2 (and similar contracts) as measured at FVTPL to eliminate the inconsistency described above.

Consider this….

• If company Z does not elect to apply the fair value option and measure contract 2 at FVTPL, it may elect to apply hedge accounting to contract 3. Since contract 3 is a derivative that was entered into to hedge the risks arising from the domestic oil seeds purchase contracts (similar to contract 2), it may be designated in a hedging relationship provided it meets the qualifying criteria. However, hedge accounting for hedges of risks arising from non-financial items is often complex due to the large volumes involved and the absence of individual correlation between the derivatives (hedging instruments) and the hedged items when managing net exposures. Therefore, the use of the fair value option generally involves lower cost and effort.

• The existence of a past practice of net settlement is a matter of judgement since Ind AS 109 does not specify any bright lines or thresholds. Infrequent and unforeseeable incidents of net settlement in the past would generally not be considered as indicative of a past practice of net settlement for all similar contracts.



Accounting for financial guarantee contracts

Ind AS 109, Financial Instruments includes within its scope, an issuer’s rights and obligations arising under an insurance contract that meets the definition of a financial guarantee contract. A scope exemption is available for such contracts only when an issuer had previously asserted explicitly that it regards such financial guarantees as insurance contracts and has used accounting that is applicable to insurance contracts under Ind AS 104, Insurance Contracts.

In this case study, we analyse how to identify a financial guarantee contract (as defined in Ind AS 109) and the appropriate accounting treatment to be followed by the issuer and the holder.

Key terms of the contractSubsidiary company S enters into a term loan arrangement with bank B on 1 April 2016 on the following terms:

Contractual features Details

Term 5 years

Loan amount INR100 million

Interest 11 per cent per annum, payable quarterly

Principal repayment 20 quarterly instalments

Guarantee Parent company P (the flagship company of the group) provides a guarantee to bank B – to make payment of the amount due if company S fails to make a payment within 30 days after it falls due. (Any subsequent recoveries are utilised to reimburse company P for amounts paid under the guarantee).

Guarantee fee/premium Nil

Company P has made no assertion in its business documentation or its previous financial statements that it regards financial guarantee contracts as insurance contracts.

Company S has estimated the fair value of the guarantee (using the principles of Ind AS 113, Fair Value Measurement) as INR5 million based on the premium/fee that it would be required to pay to a market participant (e.g., a bank) to provide a similar guarantee at 1 April 2016.

Accounting issueCompany P

The parent company P is required to analyse whether the guarantee provided to bank B meets the definition of a financial guarantee contract and should be recognised at its fair value under Ind AS 109.

Company S

Company S is the beneficiary of the guarantee. While Ind AS 109 does not specifically apply, company S may reflect the financial guarantee contract appropriately in its financial statements on the same principles as those applied by company P .

Bank B

The holder of the financial guarantee is required to assess whether this guarantee is within the scope of Ind AS 109 or should be accounted for separately.



Accounting guidance and analysisScope and definition

Ind AS 109 defines a financial guarantee contract as ‘a contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.’ Based on this definition, the contract between company P and bank B qualifies as a financial guarantee contract only if it meets all the conditions illustrated in Figure 1 below.

Source: KPMG in India’s analysis, 2017 read with Ind AS 109

Figure 1: Analysis for qualifying as a financial guarantee contract

Based on the analysis above, the contract between company P and bank B meets the definition of a financial guarantee contract and will fall within the scope of Ind AS 109.

Recognition and measurementGuarantor – Company P

Ind AS 109 requires the guarantor to recognise the financial guarantee contract initially at its fair value. Since

company P is the parent entity of the beneficiary, company S, there will be no impact at a consolidated level. However, P will be required to recognise a liability in its separate financial statements for the fair value of the financial guarantee. As no payment is made by S to P, this may be considered as a deemed capital contribution by company P to its subsidiary, since the guarantee has been provided by P in its capacity as a shareholder.

Subsequently, this guarantee is to be measured at the higher of an amount determined based on the expected loss method (as per guidance in Ind AS 109) or the amount originally recognised less, the cumulative amount recognised as income on a straight-line basis in accordance with Ind AS 18, Revenue.

Is the reference obligation a debt instrument

Is the holder compensated only for a loss that it incurs?

Is the holder not compensated for more than the actual loss

incurred?

Guidance Analysis

Yes

Yes

Yes

No

No

No


Yes - the contract guarantees the term loan (a debt instrument) provided by bank B to company S

Yes - company P will compensate bank B only in the event that company S fails to make a payment

within 30 days after it falls due

Yes - company P will compensate bank B only for losses incurred (any subsequent recoveries from

company S are repaid to company P)

The contract qualifies as a financial guarantee contract

If the guarantee contract does not meet one of the three conditions, it may be a credit derivative contract


The following is the accounting treatment in the separate financial statements of company P.

Date Accounting entry Amount in INR

1 April 2016 On initial recognition of the financial guarantee

Investment in SFinancial guarantee liability

Dr 5,000,000Cr 5,000,000

31 March 2017 Subsequent recognition of income on a straight line basis (assuming expected loss is less than the unamortised liability amount)

Financial guarantee liabilityGuarantee income

Dr 1,000,000Cr 1,000,000


1 April 2016 On initial recognition of the financial guarantee

Prepaid expense (guarantee premium)Equity

Dr 5,000,000Cr 5,000,000

31 March 2017 Subsequent recognition of income on a straight line basis (assuming expected loss is less than the unamortised liability amount)

Guarantee expensePrepaid expense (guarantee premium)

Dr 1,000,000Cr 1,000,000

Beneficiary – Company S

Ind AS 109 does not apply to the beneficiary of a financial guarantee contract. In an arm’s length transaction between unrelated parties, the beneficiary would recognise the guarantee fee or premium paid as an expense. However, in the illustration above, company S does not pay a premium to its parent entity for providing this financial guarantee.

Therefore, company S would be required to develop and consistently apply an accounting policy to recognise the impact of this financial guarantee contract in its separate financial statements.

One view is that the subsidiary should mirror the accounting treatment in the separate financial statements of the

parent entity. Therefore, company S should recognise the fair value of the guarantee as an equity infusion by the parent as follows.

On consolidation, the transactions recognised in the separate financial statements of the parent and subsidiary companies will be eliminated.

An alternative view may be that the guarantee is an integral part of the borrowing and the subsidiary company merely recognises the guaranteed borrowing from the bank at its fair value, being the nominal amount of proceeds received. The financial guarantee from the parent is not recognised separately. On consolidation, the parent entity should reverse the accounting entries relating to the financial guarantee that were recognised in its separate financial statements.

Holder – Bank B

Ind AS 109 does not provide any specific guidance on accounting by the holder of a financial guarantee. A holder may develop and consistently apply an accounting policy for such contracts under Ind AS.

A financial guarantee contract held by an entity that is not an integral part of another financial instrument is not within the scope of Ind AS 109. If a financial guarantee is an integral element of a debt instrument held by the entity, it should not be accounted for separately. Guarantees given by parent would generally be an integral part of the loan. Such guarantees cannot be separated

from the underlying loan. The effect of the protection offered by such guarantee should be considered by the holder when measuring the fair value of the debt instrument, estimating expected cash flows and assessing impairment of the debt instrument.

Source: KPMG in India’s analysis, 2017




Consider this….

• A guarantee contract that requires the guarantor (company P in the illustration above) to make a payment to the holder (bank B) when a loss has not been incurred, for example, based on changes in the credit rating of company S, does not meet the definition of a financial guarantee contract. Similarly, guarantee contracts that fail any one of the three conditions in Figure 1 above are not financial guarantee contracts as defined in Ind AS 109. Such contracts may be considered credit derivatives and measured at fair value with changes in fair value recognised in the statement of profit and loss (fair value through profit or loss).

• Other features that may result in guarantee contracts being considered credit derivatives include those that require the guarantor to make payments in response to changes in a specified variable (e.g., credit index, interest rates, etc.) or when the debtor fails to make payment within a specified credit period. However, in the latter case, if subsequent recoveries from the debtor are used to repay the guarantor such contracts may still qualify as financial guarantee contracts.

• In the example above, if the subsidiary company S pays the parent company P a guarantee commission/premium, company P is required to determine if this premium represents the fair value of the financial guarantee contract. If the premium is equivalent to an amount that company S would have paid to obtain a similar guarantee in a stand-alone arm’s length transaction, then the fair value of the financial guarantee contract at inception is likely to equal the premium received. Company P should recognise a liability for the amount of premium received and subsequently measure the financial guarantee contract at the higher of the amount of loss allowance determined in accordance with Ind AS 109 and the amount initially recognised, less cumulative amount of income recognised (based on amortisation of the premium) in accordance with Ind AS 18.

• A parent company may provide a letter of comfort or support to its subsidiary, stating that a further equity investment would be made in the subsidiary, as required, to enable the subsidiary to discharge its financial liabilities. However, this may not entail an obligation to compensate a lender when the subsidiary fails to make payments when due. Companies should carefully evaluate the terms of such arrangements to determine whether they meet the definition of a financial guarantee contract.



Derivatives


Foreign currency embedded derivatives

Ind AS 109, Financial Instruments provides guidance on accounting for derivatives and embedded derivatives. A derivative is defined as ‘a financial instrument or other contract within the scope of this standard with all three of the following characteristics: • Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign

exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract,

• It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, and

• It is settled at a future date.’

Companies may also enter into contracts that are not derivatives in themselves but include a derivative feature. This is known as an ‘embedded derivative’. An embedded derivative is a component of a hybrid (non-derivative, financial or non-financial) contract and results in some or all of the cash flows varying in a manner similar to a stand-alone derivative. Embedded derivatives in financial assets are not separately recognised, however those in financial liabilities or in non-financial contracts are separated and accounted for as a derivative if they meet the following conditions:• Their economic characteristics and risks are not closely related to the economic characteristics of the host contract,

• A separate instrument with the same terms as the embedded derivative meets the definition of a derivative, and

• The hybrid contract is not classified and measured at Fair Value Through Profit or Loss (FVTPL).

In this case study we describe the guidance in Ind AS 109 relating to identifying and separating foreign currency embedded derivatives present in non-financial host contracts with the help of an illustrative example.

Illustration - Key terms of the non-financial contractCompany A, an Indian company whose functional currency is INR, enters into a contract to purchase machinery from an unrelated local supplier, company B. The functional currency of company B is also INR. However, the contract is denominated in USD, since the machinery is sourced by company B from a US based supplier. Payment is due to company B on delivery of the machinery. Table 1 specifies the key terms of the contract:


Contract/order date 9 September 2016

Delivery/payment date 31 December 2016

Purchase price USD1,000,000

USD/INR Forward rate on 9 September 2016 for 31 December 2016 maturity 67.8

USD/INR Spot rate on 9 September 2016 66.4

USD/INR Forward rates for 31 December, on:

30 September31 December (spot rate)

67.5

67

Accounting issueCompany A is required to analyse if the contract for purchase of machinery (a capital asset) from company B contains an embedded derivative and whether this should be separately accounted for on the basis of the guidance in Ind AS 109.

Table 1: Key terms of the contract



Accounting guidanceFigure 1 illustrates the guidance in Ind AS 109 on determining whether an embedded foreign currency feature should be separated and recognised as a derivative.


Is the hybrid contract a financial asset within the scope of Ind AS 109

Classify entire contract as FVPTL/FVOCI/Amortised cost as per guidance in Ind AS 109

Is the embedded derivative ‘closely related’ to the host, i.e., either

• Denominated in the functional currency of a substantial party,

• Routinely denominated in that currency in global transactions, or

• Denominated in a currency that is commonly used in that economy

Is the hybrid contract measured at FVTPL?

Does the embedded derivative meet the definition of a stand-alone derivative

Embedded derivative is bifurcated and separately recognised as a derivativeEmbedded derivative is not bifurcated

No

Yes

Yes

Yes

No

Yes

No

Figure 1: Guidance for separation of foreign currency embedded derivative

No

AnalysisBased on the guidance above, the USD contract for purchase of machinery entered into by company A includes an embedded foreign currency derivative due to the following reasons:

• The host contract is a purchase contract (non-financial in nature) that is not classified as, or measured at FVTPL.

• The embedded foreign currency feature (requirement to settle the contract by payment of USD at a future date) meets the definition of a stand-alone derivative – it is akin to a USD-INR forward contract maturing on 31 December 2016.

• USD is not the functional currency of either of the substantial parties to the contract (i.e., neither company A nor company B).

• Machinery is not routinely denominated in USD in commercial transactions around the world. In this context, an item or a commodity may be considered ‘routinely denominated’ in a particular currency only if such currency was used in a

large majority of similar commercial transactions around the world. For example, transactions in crude oil are generally considered routinely denominated in USD. A transaction for acquiring machinery in this illustration would generally not qualify for this exemption.

• USD is not a commonly used currency for domestic commercial transactions in the economic environment in which either company A or B operate. This exemption generally applies when the business practice in a particular economic environment is to use a more stable or liquid foreign currency (such as the USD), rather than the local currency, for a majority of internal or cross-border transactions, or both. In the illustration above, companies A and B are companies operating in India and the purchase contract is an internal/domestic transaction. USD is not a commonly used currency for internal trade within this economic environment and therefore the contract would not qualify for this exemption.

Accordingly, company A is required to bifurcate the embedded foreign currency derivative from the host purchase contract and recognise it separately as a derivative.

Accounting treatmentThe separated embedded derivative is a forward contract entered into on 9 September 2016, to exchange USD 1,000,000 for INR at the USD/INR forward rate of 67.8 on 31 December 2016. Since the forward exchange rate has been deemed to be the market rate on the date of the contract, the embedded forward contract has a fair value of zero on initial recognition.

Subsequently, company A is required to measure this forward contract at its fair value, with changes in fair value recognised in the statement of profit and loss. The following is the accounting treatment at quarter-end and on settlement, based on the terms specified in Table 1. (These accounting entries are illustrative in nature and exclude the impact of discounting as well as the deferred tax adjustments for simplicity).




9 September 2016 On initial recognition of the forward contract(No accounting entry recognised since initial fair value of the forward contract is considered to be nil)

30 September 2016 Fair value change in forward contractForward contract asset (company B) ((67.8-67.5)*1,000,000)Profit or loss

Dr 300,000Cr 300,000

31 December 2016 Fair value change in forward contractForward contract asset (company B) ((67.8-67)*1,000,000-300,000)Profit or loss

Dr 500,000Cr 500,000

31 December 2016 Recognition of machinery acquiredProperty, plant and equipment (at forward rate)Forward contract asset (company B)Creditor (company B)

Dr 67,800,000Cr 800,000Cr 67,000,000

31 December 2016 Settlement – payment to company BCreditor (company B)Bank

Dr 67,000,000Cr 67,000,000




Consider this….• While the payment made by company A to company B for purchase of the

machinery is INR67 million, based on the spot exchange rate on the date of delivery, the amount capitalised to property, plant and equipment is INR67.8 million. Therefore, the cost of purchase of the machinery in INR (being the host contract) is ultimately measured at the forward rate on the date of the contract and the additional INR0.8 million is recognised in the statement of profit and loss as the fair value change in the separated embedded derivative (USD-INR forward exchange contract).

• Although company B sourced the machinery from a US based supplier and hence, the cost of the machinery supplied to company A may be based on its USD price, this does not preclude separation of the embedded derivative from the host contract.

• However, if the US based supplier is a related party of company B and the contract could not have been fulfilled by company B (considering the requisite resources or technology to fulfil the contract) independently, further analysis may be required to determine if the supplier is also a ‘substantial party’ to the contract. If so determined, then the embedded foreign currency derivative may not require separation since USD is the functional currency of the supplier, being a substantial party to the contract.

• An extension in the contract term due to delay in delivery of the machinery by company B would also result in an extension in the term of the embedded foreign currency derivative. This would be similar to a roll-over of the derivative at a forward exchange rate that is determined on the basis of the market forward exchange rate for the new date of delivery.

• Companies may enter into purchase or sale contracts that are denominated in a foreign currency in order to manage the currency risk on another exposure. For example, an Indian company that has sales denominated in EUR may enter into a EUR denominated contract to purchase machinery from an entity that has a JPY functional currency. This may act as a ‘natural hedge’ enabling the company to use its EUR inflows to make a payment to the supplier. However, such ‘third currency’ contracts would have to be assessed to determine if they contain a foreign currency embedded derivative.




Put options written on non-controlling interests

An entity may enter into business arrangements with other businesses or investors for various purposes including joint development of real estate, financing construction of infrastructure, obtaining technical know-how or market access, etc. These arrangements may involve one entity acquiring a controlling interest in an existing business or each party acquiring equity interests in an entity or venture that is being established. Some of these arrangements may require an entity (generally, the controlling entity) to provide minority investors with a mechanism to exit their investment after a certain period of time, by writing a put option to the investors in relation to their equity interest.

In this case study we will analyse the classification and measurement requirements for put options written by an entity in favour of the non-controlling interest (NCI) holders of its subsidiary.

Key terms of financial instrumentsOn 1 April 2016, company P (the company or the entity), a listed real estate developer entered into an agreement with company S, to develop 100 acres of land belonging to company S into a residential real estate project. Both companies would acquire equity interests in a newly established company, PS. The new company (PS) would have a total share capital of INR1,000 million, with company P holding 65 per cent of the shares and company S holding the remaining 35 per cent. Company P controls company PS, which is therefore considered to be its subsidiary.

As part of the shareholders’ agreement, company P has written a put option in favour of company S. This provides company S with a right to sell its shares in company PS at any time after a period of five years at a fixed exercise price being equal to the amount invested by company S plus a return of 12.5 per cent per annum. The exercise price would be adjusted for any dividends paid to company S prior to the exercise date, such that the overall return received by company S would be 12.5 per cent per annum. On exercise of this option, company P would be liable to acquire the entire shareholding of company S either for cash or for a variable number of ordinary shares of company P. Company P and company S are entitled to a dividend (whenever declared by company PS) in the proportion of their shareholding until the time that the put option is exercised.

The option will remain exercisable until such time that company P controls company PS. If company P decides to exit its investment in company PS while the option remains unexercised, it may do so only if the acquiring entity provides a similar right to company S.

Accounting issueCompany P needs to determine the classification and measurement requirements that apply to the put option in its stand-alone as well as consolidated financial statements.


AnalysisConsolidated financial statements of the issuer

Ind AS 110, Consolidated Financial Statements requires company P to consolidate company PS since it controls this entity. In the consolidated financial statements, the put option written by the company represents the group’s obligation to acquire one class of its own non-derivative equity instruments (shares in company PS) by delivering either cash, or a variable number of a different class of its own equity instruments (shares in company P).

In the absence of direct guidance in Ind AS 32, Financial Instruments: Presentation or Ind AS 109, Financial Instruments, the company P may elect an accounting policy based on either of the following approaches.

Approach 1 – Put option recognised separately as a derivative liability

The shares issued by the subsidiary to NCI holders are considered as equity instruments, being ownership interests in the consolidated group and the put option is recognised separately. The company may elect to apply one of the

following two accounting policies for measurement of the put option liability:

Recognise a financial liability for the present value of the exercise price of the put option: In accordance with Ind AS 32, the put option represents a contractual obligation for the company to purchase its own equity instruments for cash/another financial asset. Therefore, the company should recognise the present value of the amount payable on exercise of the option as a financial liability.

The IFRS Interpretations Committee has considered the issue of recognition of change in the carrying amount of such a put liability and indicated that under IFRS, companies could elect to present such changes either in profit or loss or in equity. If the same interpretation were applied under Ind AS, then the company could elect and consistently adopt an accounting policy for recognising the change in the present value of the amount payable on exercise of the put option, on each reporting date, either in profit or loss or equity.

In accordance with the principles of Ind AS 110, the other impact of this transaction may be recognised on the basis of the NCI’s present access to the

returns associated with the underlying shares (participation in fair value changes and rights to receive dividends). In the illustration above, the NCI holders would continue to receive dividends on the shares held in company PS until the exercise of the put option. However, the option is exercisable at a fixed price that is adjusted for any dividends previously paid and the NCI holders cannot participate in the subsequent fair value changes in their shares. This indicates that the NCI does not have present access to all returns associated with an ownership interest in the shares. Therefore, the other impact of the put option transaction should be recognised as a debit to NCI (anticipated acquisition method) in the consolidated financial statements.

Recognise put options as derivative liabilities at FVTPL: If the company elects to apply this accounting policy, it is required to account for put options separately as derivative liabilities measured at their fair value through profit or loss (FVTPL) in the consolidated financial statements. On initial recognition of the derivative liability, the company should also evaluate an appropriate accounting treatment for the corresponding impact.

Accounting guidanceFigure 1 below illustrates the accounting treatment for the written put option in the consolidated financial statements of the issuer.

Figure 1: Accounting for written put options on NCI

Source: KPMG in India’s analysis, 2017 read with Insights into IFRS, KPMG IFRG Ltd’s publication, 13th edition, September 2016


Put option requires payment in cash

Put option allows settlement in cash or shares of parent

(select one of two approaches)

Does NCI have present access to returns

Present access method

Approach 1(select one of two

accounting policies)

Derivative liability at FVTPL

Classify shares of subsidiary together with put option as financial

liability

Approach 2

Dr Other equityCr Option liability

Dr Non-controlling interestCr Option liability

Anticipated acquisition method

NoYes


For example, one alternative could be to debit equity since this represents a cost of its investment in company PS. The equity shares held by NCI (company S) would continue to be classified and presented as equity instruments. Subsequent changes in the fair value of the derivative liability should be recognised in profit or loss.

Approach 2 – Classify shares held by NCI together with the put option as financial liabilities

Under this approach, the company may apply the guidance in Ind AS 32 by considering all the contractual terms and conditions between the group and the NCI holders. This would require analysing the shares in company PS held by company S together with the put option written by company P in favour of company S. On a combined analysis of these instruments, the substance of the contractual terms states that there is a contractual obligation for the parent entity (company P) to deliver cash or a variable number of shares to the NCI holder at a future date, in exchange for the shares held in the subsidiary.

Therefore, the shares held by NCI, together with the put option, effectively meet the definition of a financial liability and are recognised as such in the consolidated financial statements. (Refer pages 18 to 28 for case studies on equity and liability classification.)

Stand-alone financial statements of the issuer

In the example above, the put option written by company P in favour of company S to acquire the latter’s shareholding in company PS, will be settled by payment of a fixed amount of cash or a variable number of shares of company P (based on the cash amount payable and the fair market value of shares of company P).

At an entity-level, the option is a derivative instrument that obliges the company to acquire a financial asset (being shares of company PS) at a fixed price on a future exercise date. The option may be settled in cash or in a variable number of the company’s own equity instruments, indicating that it does not meet the criteria for equity

classification in Ind AS 32. (Refer page 22 for a case study on classification of a financial instrument as equity or financial liability.)

In accordance with Ind AS 109, the company should therefore recognise the option as a derivative liability measured at FVTPL in its standalone financial statements. The fair value of the option may be computed using a valuation technique such as an option pricing model and the company may consider involving a valuation expert for this purpose. The company should also assess an appropriate accounting treatment for the corresponding impact on initial recognition of the derivative liability. For example, in this scenario, this impact could be recognised as an adjustment to the cost of the investment in company PS, since the option has been written by the company in relation to this investment. Subsequent changes in the fair value of the derivative liability should be recognised in profit or loss.


Consider this….• The accounting treatment for put options written in favour of NCI can be complex and

should be based on a careful analysis of facts and circumstances, including the specific contractual terms related to the transaction. In addition, companies should clearly disclose the related accounting policy choices in their financial statements.

• An entity may write a put option in favour of NCI holders in an existing subsidiary which is exercisable only on the occurrence of uncertain future events that are outside the control of both parties to the contract. In this case, the entity should account for the put option only if the terms affecting the exercisability of the option are genuine.

• If an entity chooses an accounting policy to recognise changes in the carrying amount of an NCI put option in equity, then the entity should include all changes in the carrying amount of the liability, including the accretion of interest in equity. Further, in accordance with the interpretation considered by the IFRS Interpretations Committee, the accounting policy choice to recognise changes in the present value of the exercise price in equity would not be available if a parent entity has entered into a forward agreement with the NCI holder to sell the shares held in a subsidiary to the parent at a future date.

• If company PS was a joint venture between company P and company S, the written put option on company S would have to be recognised as a freestanding derivative even in the consolidated financial statements. This would be recognised and measured at FVTPL, where the fair value would be generally determined on the basis of an option pricing model. Subsequent changes in fair value would be recognised in the statement of profit and loss. This is because a joint venture is an equity accounted investee (not considered to be part of the group in the consolidated financial statements) and the put options written by the entity would not represent a contractual obligation to acquire a class of its own equity instruments (in contrast, equity instruments in a subsidiary are considered to be part of the group’s own equity).


Equity and financial liability classification


Classification of convertible preference shares

Ind AS 32, Financial Instruments: Presentation establishes principles for the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments.

Ind AS 32 requires the issuer of a financial instrument to classify the instrument, or its component parts, on initial recognition in accordance with the substance of the contractual arrangement and the definitions provided in the standard.

In this case study, we analyse the key terms of an Optionally Convertible Preference Share (OCPS) to determine its classification and accounting treatment.

Key terms of the financial instrumentCompany X issues 2,000 OCPS on 1 April 2016 with the following key features:


Term 5 years

Face value INR1,000 each, issued at par

Redemption Redeemable at the end of the term on 31 March 2021

Dividend Discretionary, non-cumulative dividend of 6 per cent per annum

Conversion option Optionally convertible by the holder into ordinary shares at any time until maturity (American-style option)

Conversion ratio Each preference share is convertible into 5 ordinary shares

Company X has determined that the market interest rate for instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but with mandatory distributions and without the conversion option, as 9 per cent.

Accounting issueThe OCPS are financial instruments that are required to be classified by company X in accordance with the guidance in Ind AS 32. The subsequent accounting treatment for the OCPS is based on such classification.

Ind AS 32 requires an issuer of a financial instrument to evaluate its terms to determine whether it contains both a liability and an equity component. Such components are analysed and classified separately as either a financial liability, financial asset or an equity instrument.

The OCPS is redeemable at the end of its five year term, indicating that it contains a liability component. However, the dividend payable on the OCPS is discretionary and non-cumulative in nature. Further, the holder may also convert the OCPS into a pre-determined number of ordinary shares at any time until maturity. This indicates that the OCPS may also contain an equity component and is in the nature of a ‘compound’ financial instrument. Company X should therefore analyse each of these components separately to determine their classification.



As illustrated above, each component is analysed separately to determine its classification. The analysis, based on the guidance in Ind AS 32, indicates that:

• The redeemable principal amount of the OCPS is in the nature of a financial liability component as company X has a contractual obligation to redeem this amount to the holders at the end of the five year term,

• The discretionary, non-cumulative dividend component is an equity component since the company has no contractual obligation to pay this dividend to the holders, and

• The conversion option into a fixed number of ordinary shares is also in the nature of an equity component, since the company could be required to settle this component by issuing a fixed number of its own equity instruments.

Accounting guidance and analysisClassification of the OCPS

The following is an illustration of the relevant guidance in Ind AS 32 for classification of the OCPS and our analysis.

Figure 1: Analysis to classify the OCPS based on relevant guidance

Identify the components of the OCPS

Financial liability

Guidance Analysis of the OCPS

No

No

No

No

Yes

Yes

Yes

Yes

Source: KPMG in India’s analysis, 2017, read with Ind AS 32


Is there a contractual obligation to deliver cash/ another financial asset?

Can the component be settled in the issuer’s own equity

instruments?

Is the component a derivative that meets the ‘fixed for fixed’

criterion?

Do all settlement alternatives result in equity classification?

Redeemable principal amount

Discretionary, non-cumulative distribution

Holder’s option to convert into ordinary

shares

Yes No No

No Yes

Yes

Yes

Equity EquityFinancial liability Equity


Initial recognition amounts

Ind AS 32 requires the issuer to first determine the carrying amount of the liability (redeemable principal component) by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component.

The carrying amount of the equity instrument represented by the discretionary dividend stream and the option to convert the OCPS into ordinary shares should be determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

Figure 2 illustrates the process for allocation of the initial carrying amount of the OCPS into its liability and equity components.

Accounting treatmentThe following are the illustrative accounting entries on initial recognition and for subsequent measurement of the OCPS, assuming conversion occurs at the end of the first year.


1 April 2017 On initial recognition of the OCPS

Bank (2,000*1,000 per share)OCPS liability (2,000*650)Equity (2,000*350)

Dr 2,000,000Cr 1,300,000Cr 700,000

31 March 2017 Accrual of interest for year 1

Interest expense (1,300,000*9%)OCPS liability

Dr 117,000

Cr 117,000

31 March 2017 Assuming that the OCPS is converted into equity at the end of year 1

OCPS liabilityEquity (To be split between equity and securities premium)

Dr 1,417,000Cr 1,417,000



Figure 2: Allocation of initial carrying amount of OCPS

Fair value of the entire OCPS (INR1,000)

Fair value of liability component (INR650)(INR1,000 discounted at 9 per cent over 5 years)

Residual equity component (INR350)(INR1,000 - INR650)



Consider this….• An instrument that is redeemable in cash may also include an equity

component based on its other terms. In the illustration above, a holder’s option to convert the OCPS into a fixed number of ordinary shares is classified as an equity component. The amount attributable to this equity component on initial recognition shall remain in equity and will not be reclassified even if the OCPS are ultimately redeemed in cash by the issuer.

• The OCPS include a discretionary dividend component, which is also classified as equity. If the issuer declares and pays a distribution on the OCPS, this is considered to be an equity distribution/dividend payment and not an interest expense.

• The interest expense recognised by the issuer on the liability component represents the unwinding of the discount applied in determining the fair value of this financial liability at the time of initial recognition.



Preference shares convertible into a variable number of shares

In determining whether to classify a financial instrument (or its components) on initial recognition as a financial liability or as equity, Ind AS 32, Financial Instruments: Presentation requires an entity to assess the substance of a contractual arrangement rather than its legal form. Accordingly, an entity needs to consider all of the terms and conditions of the financial instrument. Therefore, it is possible for an instrument that qualifies as equity for legal or regulatory purposes, to be classified as a financial liability under Ind AS.

Given the complexity of some of the arrangements which companies enter into for raising funds from investors, a thorough analysis may be required before the classification of the arrangement can be determined.

In this case study we consider a common area of application of debt equity classification involving instruments where an issuer company is obliged to convert an instrument into a variable number of its own ordinary shares. Such arrangements are common in situations where companies have sought funding from private equity investors. Funding arrangements with an assured rate of return could result in a liability classification even if the legal form of the instrument may be equity. Similarly, while an instrument that is compulsorily convertible into fixed number of shares may be classified as equity, any feature linked to subsequent issue of shares at a value below the conversion price may result in increased complexities. We consider some of these issues with the help of an example below.

Illustrative exampleZ Private Limited (the company), is in the process of expanding its business and has received an investment from ABC Holdings, a private equity investor, to which it has issued compulsorily convertible preference shares (CCPS) on 1 October 2016. Following are the key terms of the preference shares:

Particulars Key terms of preference shares

Description 1,000,000, cumulative preference shares of INR100 each, issued at par (INR100,000,000)

Dividend No mandatory distributions are payable to the CCPS holders

Optional conversion Convertible into 1 equity share each at the option of the holder at any time prior to maturity

Conversion price INR100 per CCPS

Adjustments to conversion ratio for optional conversion

If the company subsequently issues additional equity instruments at a market price (effective price) that is below the conversion price per preference share, then the conversion price shall be reduced to the effective price and the conversion ratio shall be adjusted accordingly.

Conversion at maturity if not optionally converted by the holder

Convertible into a variable number of shares at maturity (30 September 2021) based on a formula as follows:

No of shares issued on conversion = Amount invested + 14% per annum Equity share price (fair value)



Accounting issueThe company is required to classify the compulsorily convertible preference share, or its components as a financial liability or an equity instrument.

Accounting guidanceThe following is an illustration of the relevant guidance in Ind AS 32 for classification of financial instruments as equity or a financial liability:

AnalysisThe CCPS has three components:

• the holder’s option to convert the CCPS into a fixed number of shares prior to maturity subject to adjustments in the conversion ratio if additional shares are issued at a market price below the conversion price (down round protection)

• the principal amount that is convertible into a variable number of ordinary shares of the issuer (Z Private Limited) on maturity, and

• the guaranteed return of 14 per cent per annum that forms part of the amount converted into a variable number of shares at maturity conversion option.

The components of the CCPS are analysed for classification as follows.

Holder’s option to convert into a fixed number of shares

The CCPS are convertible at the option of the holder into a fixed number of equity shares of the company prior to

maturity. This conversion option is a derivative instrument that is analysed for classification as an equity or financial liability on initial recognition of the CCPS. The option requires the company to deliver a fixed number of its own shares for a fixed amount of another financial asset (1 ordinary share for every CCPS held) indicating that it may meet the ‘fixed for fixed’ criterion for equity classification under Ind AS 32.

‘Down round’ protection feature

However, it is also important to consider the anti-dilution clause for adjustments to the conversion ratio. Adjustments that alter the conversion ratio only to prevent dilution of the interest held by the preference shareholders (due to dividends paid on ordinary shares, bonus issues, stock splits, etc.) do not violate the fixed-for-fixed requirement. Therefore, such anti-dilutive terms do not result in the instrument being classified as a financial liability. ‘Anti-dilutive’ clauses are those that adjust the conversion ratio to compensate holders for changes in the number of equity instruments outstanding that relate to

share issuances or redemptions not made at fair value. These do not include any other form of compensation to the preference share holder for fair value losses - e.g. when the conversion ratio is adjusted if the share price falls below a predetermined level, or if new shares are issued at a then-current market price that is below the conversion price.

In the illustration above, the conversion ratio is subject to change if additional shares are issued at a market price that is lower than the conversion price for the CCPS. This indicates that the variation in conversion ratio is intended to preserve the value of the interest held by the preference shareholders and is not in the nature of an anti-dilutive clause. This is also known as a ‘down round’ protection feature. In summary, the conversion option is a derivative feature that would not meet the ‘fixed for fixed’ criterion and would be classified as an embedded derivative liability.


Figure 1: Classification of issued financial instruments in accordance with Ind AS 32

Does the instrument contain an obligation to deliver cash or another financial asset?

Is the instrument a non-derivative that will be settled in the entity’s own equity instruments?

Does the entity have an obligation to deliver variable number of its own equity instruments?

Financial liability

Financial liability

Is the instrument a derivative that will be settled other than by an entity exchanging

fixed amount of cash or another financial asset for fixed number of its own equity

instruments (fixed for fixed)?

Equity

No

No

No

No

Yes

Yes

Yes

Yes



Conversion into variable number of shares

The principal amount or the amount invested by CCPS holders along with an assured return computed at 14 per cent per annum, is convertible into a variable number of shares on maturity of the CCPS, i.e. on 30 September 2021. The conversion ratio or number of shares to be delivered by the company will be determined based on an equity fair valuation as on the date of conversion, using the formula below:

No of shares issued on conversion = (Amount invested + 14% per annum)/Equity share price (fair value)

For example, the amount invested (INR100 per CCPS) along with a compounded return of 14 per cent per annum would amount to approximately INR192 per CCPS at 30 September 2021, i.e. INR192 million in aggregate. If the fair value of one ordinary share of Z Private Limited is INR120 as on 30 September

2021, the company would be required to issue 1.6 million ordinary shares (192 million/120) on conversion of the CCPS at maturity. Conversely, if the fair value of one ordinary share of the company is INR240, the company would be required to issue 0.8 million ordinary shares (192 million/240) to the CCPS holders at maturity.

The CCPS is therefore in the nature of a non-derivative contract that will be settled in a variable number of the issuer’s own equity instruments (refer Figure 1 above). This is because the company is in effect using its own shares as currency and the holder would not be exposed to any gain or loss arising from movements in the fair value of equity instruments. This indicates that the CCPS principal amount and the assured return of 14 per cent per annum are financial liabilities of the company in accordance with Ind AS 32.

Accounting treatment for the components of the CCPS

As discussed above, the CCPS is considered a ‘hybrid’ financial liability, i.e. comprising the following two components:

• A host non-derivative liability component for the interest and principal amount, and

• A separable derivative component (i.e. the holder’s option to convert into shares).

Ind AS 109 requires the separable embedded derivative to be measured at fair value on initial recognition, with subsequent changes in fair value recognised in profit or loss. The CCPS is therefore split into its components on initial recognition as illustrated in figure 2 below.

On initial bifurcation of the derivative component, no gain or loss should be recognised by the company. The initial recognition amount for the non-derivative liability component is determined as the difference between the fair value of the combined CCPS instrument (usually the transaction price) and the fair value of the embedded derivative.

The liability component is subsequently measured at amortised cost using the effective interest rate (EIR) method. The EIR is computed as the rate that discounts the future contractual cash flows (the principal amount and the assured return of 14 per cent per annum) to the carrying amount initially recognised by the company.

Alternatively, the company may designate the entire hybrid contract as a financial liability measured at fair value through profit or loss on initial recognition. The entire CCPS would then be measured at fair value with changes in fair value recognised in profit or loss.


Figure 2: Bifurcation of CCPS into embedded derivative and host financial liability

CCPS(Hybrid financial instrument)

Embedded derivative (measured at fair value on initial recognition)

Host financial liability (fair value of combined CCPS less fair value of

embedded derivative)



Consider this….• Companies should consider the impact of any clauses that alter the conversion

ratio for instruments (or components) that are settled by delivery of an entity’s own equity instruments. This can pose a challenge due to the increasing complexity in the terms of structured instruments. For example, careful analysis would be required for a change in the conversion ratio to compensate a preference shareholder as a result of a rights issue, where the issuance of shares is not at fair value. While such adjustments may not vitiate the ‘fixed for fixed’ criterion for equity classification, this should be determined based on a detailed analysis of the contractual terms of the instruments.

• Preference shares that include an element of guaranteed/assured returns are often a feature of investments in structured instruments made by private equity or venture capital investors. These features are designed to provide the investor with a minimum return on exit. The assured minimum return may be in the form of a cash obligation of the issuer or the requirement to issue additional shares to compensate for a lower fair value on conversion. Such arrangements should be carefully analysed to determine the classification of the structured instruments by investee companies.



Impact of contingent settlement provisions on classification of financial instruments

Companies may issue financial instruments to investors that require redemption on the occurrence of future events that are uncertain. Such arrangements are designed to provide an exit mechanism for the investor in adverse circumstances, for example, the issuer’s failure to list its equity instruments or a change in control of the issuer.

Ind AS 32, Financial Instruments: Presentation provides guidance on classifying a financial instrument that may require an entity to deliver cash or another financial asset, or settle it in such a way that it would be classified as a financial liability, only on the occurrence or non-occurrence of uncertain future events. Such events may be beyond the control of both the issuer and the holder of the instrument. These arrangements are referred to as ‘contingent settlement provisions’.

In this case study we illustrate how the inclusion of a contingent settlement

provision in convertible preference shares issued by an entity may impact the classification of the preference shares.

Key terms of the financial instrumentABC Private Limited (the company or the entity) is an operating e-commerce company that has entered into a shareholding agreement with a private equity investor. On 1 October 2016, the company issued 2,000,000 convertible preference shares of INR100 each to the investor. The investor intends to exit its investment in the company when the company makes an initial public offer (IPO) for its ordinary shares, which is expected to occur in three years. The preference shares therefore provide for automatic conversion into 15 equity shares of INR10 each for each INR100 preference share when the IPO takes place, provided the IPO takes place within three years. If the company does

not complete an IPO within three years, the issuer is obliged to redeem the preference shares in cash for an amount equal to the amount invested plus a return of 15 per cent per annum.

Accounting issueABC Private Limited needs to assess the impact of the requirement to redeem the preference shares in cash on the non-occurrence of an IPO, on the classification of the preference shares as a financial liability or an equity instrument.

Accounting guidance and analysisFigure 1 below outlines the relevant guidance in Ind AS 32 for classification of a financial instrument containing a contingent settlement provision and includes our analysis.



Guidance Analysis of financial instrument

Identify the components of the preference shares

Redemption on non-occurence of IPO

Yes

Yes

Yes

Yes

Financial liability Equity

Conversion into fixed number of ordinary

shares on IPO

No

No

No

Is there a contractual obligation to deliver cash/

another financial asset

May the component be settled in the issuers’ own

equity instruments?

Is the component a derivative that meets the fixed for fixed criterion?

Do all settlement alternatives for the

derivative component result in equity classification?

Does the issuer of the financial instrument have an unconditional right to avoid making payments?

Is the contingent settlement feature

considered to be non-genuine?

Financial liability Equity

No

No

No

No

No

No

Yes

Yes

Yes

Yes

Yes

Yes


Figure 1: Classification of a financial instrument as equity or financial liability



Redemption on non-occurrence of an IPOInd AS 32 states that the issuer of a financial instrument does not have an unconditional right to avoid payment, when the issuer is required to deliver cash (or another financial asset), on the occurrence or non-occurrence of an uncertain future event that is beyond the control of both the issuer and the holder of the instrument.

In the illustration above, the issuer may be required to redeem the preference shares on the non-occurrence of an IPO. While the decision to initiate an IPO process is within the control of the issuer, its successful completion would be dependent on market conditions at that time as well as the receipt of regulatory approvals. These factors are not within the control of the issuer or the preference share holder. Accordingly, the company cannot unconditionally avoid the contractual obligation to redeem the preference shares.

Ind AS 32 also requires consideration of whether the contingent settlement provision is non-genuine in nature. Generally, a contingent settlement feature would be regarded as genuine, except in rare circumstances when it has no economic substance and may be removed by either parties to the contract without any compensation. For example, a contingent settlement feature involving a change in tax law that results in a loss of specific tax benefits for the issuer or the holder would be considered genuine even if the possibility of such an event occurring is remote. In this case study, the contingent feature has economic substance since it is intended to provide an exit with a defined return to the investor in a scenario where the investor is unable to exit the investment in an IPO. Therefore, the preference shares contain a financial liability, being the contractual obligation to redeem on non-occurrence of a contingent event, regardless of the likelihood of cash settlement.

Conversion into fixed number of sharesThe preference shares are convertible into a fixed number of ordinary shares of the company on occurrence of the contingent event, i.e. an IPO. This conversion feature is a derivative that would be settled by the delivery of a fixed number of shares on occurrence of the IPO. This indicates that this feature meets the criteria for equity classification.

Therefore, the preference shares are compound instruments with a liability and equity component. Ind AS 32 requires the company to first determine the initial recognition amount of the liability (redeemable component) by measuring the fair value of a similar liability that does not have an associated equity component. The difference between the fair value (generally, transaction price) of the combined instrument and the fair value of the liability component is recognised as the equity component.

Consider this….Other examples of contingent settlement features include scenarios where an issuer has a contractual obligation to deliver cash on payment of dividend on ordinary shares, or on the occurrence of a change in control (takeover) of the issuer, that requires approval by shareholders. The exercise of judgement, based on a careful analysis of specific facts and circumstances, is required in these situations to determine whether the shareholders of an entity are acting as a body under the entity’s governing charter

- i.e. as issuer (part of the entity), or as individual investors (not as part of the entity). Such analysis would be required to establish if the contingent feature is outside the control of the issuer and the holder, resulting in a liability classification.



Recognition and derecognition


Accounting for long-term deposits and advances

Ind AS 32, Financial Instruments: Presentation defines a financial instrument as a contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.

Some common examples of financial instruments that give rise to financial assets for the holder and corresponding financial liabilities for the issuer are trade receivables/payables, loan receivables/payables, etc. Certain assets, on the other hand, give the holder a contractual right to receive goods or services, rather than the right to receive cash or another financial asset, for example a non-cancellable prepaid insurance contract. These are not financial assets.

In this case study, we analyse various types of deposits placed and advances given to external parties to determine if these meet the definition of financial instruments. We also illustrate the principles to be considered for recognition and measurement of these instruments in the financial statements of an entity, when classifying them as financial assets.

Key terms of the financial instrumentsCompany A (the entity or the company) had the following assets in its financial statements as on 31 March 2017:

Particulars Maturity Amount in INR

On 1 October 2016, the company placed an interest-free, refundable security deposit for the operating lease of the company’s corporate office, as per the operating lease agreement.

The security deposit will be repaid to the company at the end of the lease term, which is on 30 September 2021, unless the company and the landlord reduce the lease term by issuing notice as specified in the lease agreement.

5,000,000

Interest-free deposit placed with the VAT authorities

The Value Added Tax (VAT) law requires the company to place a security deposit with the VAT authorities. This deposit may be utilised by the authorities if the company fails to make payments to the authorities.

500,000

Non-refundable capital advances made for import of machinery

As per the terms of the agreement, the machinery will be shipped only after payment of the advance. In case of damages on shipping, the machine/machine parts will be replaced free of cost.

10,000,000

Prepaid rent for the corporate office for the next 6 months

Amount will get adjusted against the monthly contractual charge. 600,000

Advance income tax paid for AY 2016-17

The advance tax will be adjusted with the provision for tax assessed by the assessing income-tax officer, any excess amount would be refunded to the company.

15,000,000

The market rate of interest on risk-free investments is 7.5 per cent per annum.



Accounting issueCompany A is required to determine whether the assets in its financial statements meet the definition of financial assets, and determine the appropriate accounting treatment under Ind AS 109, Financial Instruments for these assets.

Accounting guidanceFigure 1 below provides an illustration of the relevant guidance in Ind AS 32 for determining whether an asset is a financial instrument:

Analysis – definition of financial assetsThe assets of the company are analysed on the basis of the guidance given above:

Security deposits for operating lease

Rental/lease deposits are refundable on completion of the lease term. Accordingly, these represent a right to receive cash from the holder, arising from the contract. Hence, these meet the definition of financial assets under Ind AS 32.

Capital advances and prepaid expenses

In respect of capital advances, the company will receive machines against the advances made. Similarly, for prepaid rent, the company will be able to utilise the space and facilities of the corporate office for the next six months. Since the company adjusts/settles these advances/prepayments against the receipt of goods or services, rather than by receiving cash or another financial asset, these would not meet the definition of financial assets.

Advance tax and deposit with VAT authorities

The company makes payment of advance tax in compliance with the income tax regulations. Since there is no contractual provision for making such payment, it is not a financial instrument. Similarly, the security deposit placed with the VAT authorities is in accordance with the taxation regulations. There is no contractual agreement for placing such a deposit. Hence the security deposit is not a financial asset. The following table summarises the analysis for the various types of deposits and advances held by the company.



Type of assets Characteristics Financial asset

Security deposits for operating lease Represent a contractual right to receive cash from the issuer. Yes

Capital advances and prepaid expenses

The future economic benefit is the receipt of goods or services, rather than the right to receive cash or another financial asset

No

Advance income tax and deposit with VAT authorities

It is not based on a contract between the entity and the tax authority, but arising through statute. No

Is the asset ‘Cash’?

Asset is a financial asset

Is the asset an equity instrument of another entity?

Is the asset a contractual right to receive cash or another financial asset?

Is the asset a contractual right to exchange financial assets or financial liabilities under potentially favourable conditions?

Asset is not a financial asset

No

No

No

No

Yes

Yes

Yes

Yes



Classification and measurementClassification

Ind AS 109 requires the classification of the financial assets as subsequently measured at amortised cost or at fair value on the basis of an entity’s business model for managing the financial assets and the characteristics of the contractual cash flows for which the financial assets are held.

A financial asset would be measured at amortised cost only if it meets both the following conditions:

• the asset is held within a business model whose objective is to hold the asset to collect contractual cash flows; and

• the contractual terms of the financial assets give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (SPPI criterion)

If a financial asset does not meet both these conditions, then it is measured at fair value.

As the security deposits would be held for collecting the contractual cash flows (i.e. original amount of deposit), which is the principal amount outstanding (the interest being nil), it meets the criteria for measurement at amortised cost using the effective interest method.

Measurement

As per Ind AS 109, financial instruments are measured initially at fair value plus transaction costs on initial recognition and subsequently measured at amortised cost (if they are so classified). Ind AS 113, Fair Value Measurement, defines fair value as price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Accordingly, the fair value of the financial instrument is generally considered to be the transaction price.

However, in this illustration, the deposits are interest-free, long-term deposits- i.e. the interest is not charged at market rates and hence the transaction price does not represent the fair value. The company should, hence bifurcate the transaction price into:

• the fair value of the deposit- this would be computed using the present value technique with inputs that include (a) future cash flows and (b) discount rates that reflect assumptions that market participants would apply in pricing the financial instrument, which is 7.5 per cent in the illustration.

• The difference between the fair value of the deposits and the transaction price on initial recognition of the deposit needs to be accounted for

separately. The accounting treatment for these will depend upon the nature of the element included in the deposits. Had the entity not placed the deposits with the lessor, the monthly rentals would have been higher. This indicates that the nature of the interest-free element in these deposits represents a prepaid expense. Hence, this difference will be recognised as ‘prepaid expenses’, which will be amortised to the statement of profit and loss over the life of the deposit on a straight line basis.

• The deposits would subsequently be measured at amortised cost, which is computed using the effective interest rate. The entity should, over the period of the lease/contract, recognise and accrue in the amortised cost of deposits an interest income calculated at the effective interest rate for such deposits.


Particulars Rental deposit

Classification Amortised cost

Initial measurement INR3,482,793

Difference between the deposit amount and the amortised cost INR1,517,207

Treatment of the difference

Recognised as prepaid lease expenses on initial recognition and amortised over the life of the deposit.Interest accrued over the estimated life of the deposit on the amount recognised.



Consider this….• The accrual of interest income will result in an altered representation of lease

expenses in the statement of profit and loss over the term of the lease. Additionally, companies also need to assess the tax consequence on such notional interest income.

• Other significant practical issues that companies should consider include:

– Discounting of long-term deposits where there is no pre-defined contractual period. For example, in the infrastructure sector, it is an industry practice to place earnest money deposits (EMDs) for executing large turnkey/infrastructure projects. These EMDs are refunded to the vendor once the tender is closed irrespective of whether the contract is awarded or not. In situations like these, companies would have to estimate the period after which such EMDs are expected to be recovered based on historical trends and practices in the industry. This could pose some practical difficulties in estimating the period over which such EMDs should be discounted.

– Long-term revenue contracts, where revenue is recognised but will be received only after the expiry of a certain period, for example retention money, which is common in the construction industry. The customers usually withhold a percentage of the total contract price for a pre-defined period of time to ensure all defects have been corrected by the contractor within that period of time. In this scenario, companies should assess if they may be required to impute interest and the expected cash receipts might need to be discounted to measure the fair value of the amount receivable.

• Interest is required to be imputed when the impact of discounting would be significant. However, an entity is permitted to measure short-term receivables and payables with no stated interest rate at their invoiced amounts without discounting, if the effect of discounting is immaterial. Therefore, receivables and payables with maturities of up to six months are not generally discounted.


Derecognition of trade receivables under a factoring arrangement

Ind AS 109, Financial Instruments, provides specific guidance on derecognition of financial instruments that is relevant in analysing transactions such as an assignment of receivables, factoring and bill discounting arrangements, repurchase transactions and securitisations.

It requires a financial asset to be derecognised when:

• the rights to receive cash flows expire,

• the entity has transferred substantially all risks and rewards pertaining to the asset, and

• the entity has not retained control over the asset.

In this case study we illustrate the application of derecognition principles to trade receivables under a factoring arrangement with the help of the following example.

Key terms of the transactionScenario 1

Company S (the company) has entered into an arrangement on 1 April 2016 with bank P (the bank) to transfer its short-term trade receivables to the bank on an ongoing basis during the year ending 31 March 2017. The aggregate amount of receivables that may be transferred under this arrangement during the year is INR200 million and the maximum tenor of each receivable is specified as 120 days.

On 30 June 2016, company S has legally transferred trade receivables aggregating to INR100 million to bank P. Company S receives an initial advance amount of INR80 million from the bank. The debtors of the company have also been notified of the transfer and are required to make payments directly to the bank on the due date. On collection, the bank will pay the balance amount of the receivables to the company after deducting fees and

discounts approximating 6 per cent of the outstanding amount of receivables. In case of default by the debtor, the bank has the right to demand payment from company S, i.e. the factoring arrangement is ‘with recourse’.

Accounting issueCompany S is required to evaluate whether Ind AS 109 permits it to derecognise the trade receivables that are transferred to the bank under the arrangement described above.


Accounting guidanceFigure 1 illustrates the guidance provided in Ind AS 109 on derecognition of financial assets.



Figure 1: Derecognition of financial assets under Ind AS 109

The company would first be required to assess if it has transferred the rights to the cash flows. Such rights are considered to be transferred if, and only if, the company transfers the contractual rights to receive the cash flows from the financial asset or enters into a qualifying ‘pass-through arrangement’.

For transactions that meet the transfer requirements, the company should evaluate whether it has transferred the risks and rewards of ownership of the financial asset. The company would be permitted to derecognise a transferred financial asset if it has transferred substantially all of the risks and rewards of ownership of that asset. Conversely,

it continues to recognise a transferred financial asset if it has retained substantially all of the risks and rewards of ownership of that asset.

Perform assessment on consolidated financial statements

Derecognition principles applied to a part or all of the asset

Have the rights to cash flows from the asset expired?

Are the rights to receive cash flows from the asset transferred?

Is an obligation to pay cash flows from the asset assumed?

Have substantially all risks and rewards been transferred?

Derecognise the asset Is control over the asset retained?

Do not derecognise the asset

No

No

No

No

No

Yes

Yes

Yes

Yes

Yes


AnalysisThe following is an analysis of the transaction (transfer of trade receivables) based on the guidance above.


Derecognition criteria under Ind AS 109 (Refer Figure 1)

Applicability to factoring transaction

Is the transferee entity required to be consolidated?

No, since company S does not control bank P, the derecognition criteria are applied on a consolidated basis for company S.

Are the derecognition principles applied to a part or all of the asset?

The derecognition principles should be applied to all of the asset, i.e. the trade receivables in their entirety. (This assessment is relevant only if a part of the cash flows are transferred, e.g. only principal cash flows in an interest bearing bond).

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

No, the rights to collect cash flows from the customers (relating to the trade receivables) have not expired.

Has the company transferred the rights to receive the cash flows from the asset?

Yes, the rights to receive the cash flows have been legally transferred to bank P. In addition, the customers have been notified of the transfer and are required to discharge their obligation by making payments directly to bank P. This indicates that the company has transferred the contractual rights to the cash flows from its customers on account of the trade receivables to the bank.

Has the entity assumed an obligation to pay cash flows from the asset?

This is relevant to the derecognition assessment only when the company (i.e. the transferor) retains the contractual rights to the cash flows and assumes an obligation pass these cash flows through to the purchaser on collection, i.e. a ‘pass through arrangement’ has been established. In this illustration, the company has transferred the rights to the cash flows and has not set up a pass through arrangement.

Has the entity transferred substantially all risks and rewards?

The receivables have been transferred to the bank ‘with recourse’ to the company. This means that the company is obliged to repay the bank on default, if any, by the customers relating to the outstanding receivables. The bank pays only 80 per cent of the outstanding amount to the company on transfer of the receivables and the balance (after deduction of fees and discount) is paid only on collection from the customers. These factors indicate that the company remains exposed to the same level of credit risk on the trade receivables as it was, prior to the transfer.

Since the receivables are short-term in nature, credit risk is the most significant risk arising from these financial assets. This indicates that the company has retained substantially all risks and rewards relating to the receivables and would not be permitted to derecognise these financial assets under Ind AS 109.

Assessment The transfer of receivables to bank P would not meet the derecognition criteria and the company should continue to recognise the receivables as its financial assets. In addition, the advance received from the bank should be recognised by the company as a borrowing (financial liability).



Consider this….• A transfer of trade receivables ‘without recourse’ to the transferor may meet the

derecognition requirements of Ind AS 109 if substantially all risks and rewards have been transferred to the purchaser. However, ‘without recourse’ transactions are less common in India and detailed analysis may be required to determine if the transferor retains substantial risks in the form of exposure to any residual interests.

• Companies may enter into factoring or bill discounting transactions where they continue to collect cash flows from the underlying receivables and the details of the transfer or assignment are not disclosed to the debtors/customers. The company would then be required to pass through these cash flows to the purchaser (transferee). In this scenario, before analysing whether there has been a transfer of substantially all risks and rewards, the company should determine if the transaction qualifies as a transfer under Ind AS 109, i.e. it meets the following criteria:

– The company has no obligation to pay amounts to the transferee unless it collects equivalent amounts from the receivables

– The company is prohibited from selling or pledging the receivables other than as security to the transferee for the obligation to pay the cash flows, and

– The company has an obligation to remit any cash flows it collects on behalf of the transferee without material delay.

The criteria above may not be met in certain situations, for e.g., where the company first remits cash flows to the purchaser (generally a bank) to the extent of any advance received (i.e. the consideration) and then retains the residual amount of cash flows. Such transactions would not qualify as a transfer under Ind AS 109 and would therefore not be eligible for derecognition from the financial statements of the transferor company.


Derecognition of a financial liability

Ind AS 109, Financial Instruments requires a financial liability to be derecognised when it is extinguished, i.e. when the obligation is discharged, cancelled or expires. This may occur when:

• The borrower makes a payment to the lender towards the redemption or repurchase of a debt instrument,

• The borrower is legally released from primary responsibility for the financial liability (this condition can be satisfied even if the borrower has given a guarantee), or

• There is an exchange between an existing lender and borrower of debt instruments with substantially different terms or a substantial modification of the terms of an existing debt instrument.

In this case study we illustrate the application of derecognition principles with an example of a restructuring or refinancing of two debt instruments issued by an entity.

The company experienced an improvement in its credit rating based on its financial performance for the year ended 31 March 2016. Accordingly, on 1 April 2016 the company decided to refinance its loans as follows:

• Loan 1 was repaid in full in accordance with the original terms of the loan that permitted prepayment without penalty in the three years immediately preceding the maturity date. The company then obtained a new loan from bank A on more favourable terms, in accordance with the market rate applicable to the company based on its improved credit rating.

• The company had entered into renegotiations with bank B for modification to the terms of Loan 2. On 1 April 2016, the company finalised an agreement with bank B modifying the terms of this loan with a reduction in interest rate and an extension in the term of the loan. As part of the restructured arrangement, the company is required to pay a fee of INR2 million to bank B.

Key terms of the financial liabilitiesS Limited (the entity or the company) had the following term loans outstanding in its financial statements as on 1 April 2016.

Particulars Loan 1 from Bank A Loan 2 from Bank B

Original loan amount INR200,000,000 INR500,000,000

Transaction costs/fees INR4,000,000 INR10,000,000

Amortised cost as on 1 April 2016 INR198,319,853 INR495,895,153

Interest rate 11 per cent per annum 12 per cent per annum

Remaining term to maturity 3 years 2 years

Effective interest rate (EIR) 11.34 per cent per annum 12.49 per cent per annum

Other terms of the instrument Repayable at maturity. The company has an option to prepay anytime during the three years immediately preceding the maturity date, without any penalty.

Repayable at maturity only. Prepayment penalty of 1 per cent would be levied if prepaid.

Table 1: Key terms of original financial liabilities (term loans)



Particulars Loan 1 (new) Loan 2 (modified)

Borrowings INR200,000,000 INR500,000,000

Interest rate 9 per cent per annum 9 per cent per annum

Period of the loan 5 years 7 years

Other terms of the instrumentRepayable in 2 equal annual instalments commencing from 31 March 2020

Repayable in 5 equal annual instalments commencing from 1 April 2019

Fees for modification Nil INR2,000,000

Loan processing fees INR1,000,000 INR5,000,000

Table 2: Modified terms of the financial liabilities

The following table summarises the new terms for both loans:

Accounting issueS Limited is required to determine the appropriate accounting treatment under Ind AS 109 for the prepayment/modification of terms of the loans. This includes determining whether the existing loans should be derecognised from the company’s financial statements.

Accounting guidanceAs mentioned above, Ind AS 109 requires a financial liability to be derecognised when it is extinguished, i.e. when the obligation is discharged, cancelled or expires. An exchange between an existing borrower and lender of debt instruments with substantially different terms or a substantial modification of the terms of an existing financial liability or part thereof is accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

Figure 1 illustrates the considerations under Ind AS 109 to determine whether a modification is ‘substantial’ and the consequent accounting treatment required.




AnalysisThe following is an analysis of each ofthe financial instruments mentioned inthe tables above.

Loan 1

The company has prepaid this loan in full, in accordance with the original terms of the loan, which permitted prepayment without penalty in the three years immediately preceding maturity. This loan has been replaced by a new loan from the same lender, i.e. bank A. The company is required to assess whether the repayment and refinancing of this loan constitutes a substantial modification of terms or an exchange

of debt instruments with substantially different terms.

Since this loan was prepaid in accordance with its original terms, the repayment/settlement of the loan would not constitute a modification of terms and would result in the extinguishment of the original loan liability.

Therefore, the company should consider the original loan as extinguished and derecognise this liability. A gain or loss should be recognised based on the difference between the amortised cost/carrying amount of the original loan and the consideration paid. In this illustration, this represents the unamortised transaction costs/fees

relating to the original loan. The new loan is initially recognised at its fair value (considered as equal to the transaction price since the loan is at market rates), minus directly attributable transaction costs.

Figure 1: Analysis to determine if modification of terms is substantial

Quantitative assessment(Does the NPV of the cash flows under the new terms discounted using the original EIR, differ 10 per cent or more from the NPV of the remaining original cash flows?)

Qualitative assessment(Are there substantial differences in terms that are not captured by the quantitative assessment?)

Recognise:• Gain/loss based on

difference between carrying amount and consideration paid

• Modification costs or fees incurred included in the gain/loss

No

No

Yes

Yes

Derecognise the liability

Recognise new liability - measured at its fair value

Continue to recognise the existing financial liability (amortise

costs/fees incurred over the remaining term)



Loan 2

The company has renegotiated the terms of this loan to obtain a reduced interest rate as well as an extension in the term of the loan. Further, there has been a change in the principal repayment schedule of the loan. Ind AS 109 requires the company to assess the modified terms of the liability to determine whether the modification is substantial in nature.

Ind AS 109 states that ‘terms are substantially different if the discounted present value of the cash flows under the new terms, including any fees paid net of any fees received and discounted using the original effective interest rate, is at least 10 per cent different from the discounted present value of the remaining cash flows of the original financial liability.’ This is a quantitative assessment of the modification in terms. The company should also perform a qualitative assessment to determine if the modification is substantial, if the difference in the present values of the cash flows is less than 10 per cent.

The company has performed a quantitative assessment. In accordance with the guidance above, the present value of the remaining cash flows of

the original loan (i.e. its amortised cost) on 1 April 2016 is INR495,895,153 and the present value of the cash flows (including modification fees) under the modified terms, discounted using the original EIR (12.49 per cent per annum), is INR440,945,889. This amounts to a difference of approximately 11 per cent in the present values of cash flows under the original loan and the modified terms and would result in the extinguishment of the original loan liability.

The difference between the carrying amount/amortised cost of the original loan and the consideration paid is recognised in profit or loss. In this illustration, the consideration paid by the company is the assumption of the new financial liability (i.e. modified loan). The new financial liability is initially measured at its fair value. The fair value of the new loan is estimated as INR500 million in this illustration, based on the assumption that this loan has been provided by bank B at market rates (being 9 per cent per annum excluding any adjustment for transaction costs or fees) as applicable to the company on the date of modification. Consequently, the loss on derecognition of the loan amounts to INR4,104,847.

Ind AS 109 also requires any costs or fees incurred related to the modification to be recognised as part of the gain or loss on extinguishment. These are not adjusted in the initial recognition amount of the new financial liability unless it can be demonstrated that they relate solely to the new liability. In this illustration, the company would be required to include the modification fees of INR2 million and the transaction costs of INR5 million in the gain/loss on derecognition. This would bring the total loss on derecognition to INR11,104,847.


1 April 2016 Term loan 1 (original financial liability) Dr 198,319,853

Profit or loss Dr 1,680,147

Bank Cr 200,000,000

(Prepayment and extinguishment of original loan)

1 April 2016 Bank Dr 199,000,000

Borrowing - Term loan (new financial liability) Cr 199,000,000

(Recognition of new loan at initial fair value minus transaction costs)

The company recognises the following accounting entries:




Consider this….• A qualitative analysis of a modification in the terms of a financial liability, in order

to determine if the modification is substantial, should exclude those differences in terms that have been captured by the quantitative assessment. For example, changes in interest rates, principal amounts, extension of maturities, etc. would generally be captured in a quantitative assessment. Hence, these modifications by themselves would not indicate a qualitative modification in terms that is substantial. Examples of qualitative modifications generally include changes relating to substantial equity conversion features, security pledged by the borrower, or the currency in which the liability is denominated. Entities may be required to exercise judgement to assess if such modifications are substantial in nature.

• A modification in terms that is not substantial in nature would not result in the derecognition of the financial liability. In this scenario, any fees or costs incurred on modification are adjusted in the carrying amount of the financial liability and amortised over its remaining term.

• In a debt restructuring arrangement involving financial difficulty of the borrower, a lender may agree to modify the terms of a loan to accept a reduced rate of interest, or to provide a new loan to the company at a lower rate of interest. Such arrangements may require further consideration to assess whether the new loan has been provided at fair value and to determine the amount at which the financial liability should be recognised.

• A lender may accept a reduced rate of interest or forgive repayment of a portion of a loan under a debt restructuring arrangement on the condition that the company would continue to be liable to repay this amount from future profits, if any (a recompense arrangement). In this scenario, further analysis may be required to determine whether there is a contractual obligation to pay this amount in the future that would result in the recognition of a financial liability.

The company should recognise the following accounting entry on derecognition.



1 April 2016 Term loan 2 (original financial liability) Dr 495,895,153

Profit or loss Dr 11,104,847

Bank Cr 7,000,000

Borrowing – term loan (modified financial liability) Cr 500,000,000

(Substantial modification and extinguishment of original loan and recognition of a new financial liability)



Extinguishment of a financial liability with an equity instrument

The terms of a financial liability may be renegotiated such that an issuer either settles the liability by issuing its own equity instruments or amends the contractual terms resulting in its reclassification as an equity instrument.

Ind AS 32, Financial Instruments: Presentation requires an issuer (borrower) to reclassify a financial liability as equity from the date the instrument has all the features of an ‘equity’ instrument or vice versa. Accordingly, when an entity amends the contractual terms of a financial instrument (being a financial liability or equity instrument), the entity should assess the requirement for reclassification of such a financial instrument as a financial liability or an equity instrument.

Appendix D (Extinguishing Financial Liabilities with Equity Instruments) to Ind AS 109, Financial Instruments specifies the accounting treatment when an entity issues equity instruments to a creditor of the entity to extinguish all or part of a financial liability. This transaction is referred to as a ‘debt for equity swap’.

In this case study we illustrate the accounting treatment on renegotiation/restructuring of two financial liabilities.

Key terms of the financial instrumentsX Limited (the company) is an Indian company operating in the construction sector. Due to recent losses that have been incurred and reduced forecasts of cash inflows, the company has entered into renegotiations with its lenders and investors for restructuring certain financial instruments. The company has reached an agreement with its lenders/investor to restructure a term loan and preference shares as on 31 March 2017. The following is a summary of the original and modified terms of two financial instruments.

* In this illustration, as part of the restructuring, the company has agreed to exchange the redeemable preference shares held by investors with equity instruments that have a higher fair value on the date of modification. This is intended to compensate the investors for giving up their right to return of capital in exchange for a greater equity stake. However, in other scenarios, borrowers that are in financial distress may be unable to provide equity instruments with an equivalent fair value in exchange for their financial liability to lenders/investors.


Particulars Term loan 100,000 10.5% Cumulative Redeemable Preference shares

Carrying amount of loan/ preference shares

INR60,000,000 INR9,892,640

Interest rate 11 per cent per annum (effective interest rate) 10.5 per cent per annum cumulative distribution

Original maturity date 31 March 2021 31 March 2020

Fair value of the loan/preference shares

INR55,000,000 INR9,076,353

Restructured terms The lenders have agreed to accept 3,200,000 equity shares (face value of INR10 per share) as payment towards extinguishment of 60 per cent of the term loan. For the balance 40 per cent, the lender has extended the term of the loan by two years at a lower interest rate of 6.5 per cent per annum. The remaining loan is now repayable on 31 March 2023.

Conversion of the cumulative preference shares into 6% Non-Cumulative, Compulsorily Convertible Preference Shares. The dividends are payable at the discretion of the company. Each preference share will be converted into 10 equity shares on maturity.

Fair value of the new liability

INR17,150,000 NA

Fair value of the equity instruments issued

INR40,000,000 (INR12.5 per share) INR11,000,000*

Table 1: Key terms of the financial liabilities on 31 March 2017


Accounting issueThe company is required to determine the appropriate accounting treatment under Ind AS for the following:• Partial extinguishment of the term loan by issuance of equity shares and modification of the terms of the remaining loan, and• Change in the contractual terms of the preference shares issued by the company to its investors.

Accounting guidanceFigure 1 illustrates the accounting guidance provided in Ind AS 109 (including in Appendix D of Ind AS 109) on accounting for extinguishment of a financial liability by issuance of equity instruments:

Source: KPMG in India’s analysis, 2017 read with Insights into IFRS, KPMG’s IFRG Ltd’s publication, 13th edition, September 2016


Figure 1: Extinguishment of financial liability with equity instruments under Ind AS 109

Are equity instruments issued to fully extinguish a financial liability?

Has the balance amount of the loan been modified?

Allocate the consideration paid between

Can the fair value of the equity instruments be

measured reliably?

Derecognise extinguished loan and recognise

difference between the fair value of equity shares and the carrying amount of the

loan as gain/loss

Derecognise extinguished loan and recognise

difference between the fair value of the financial liability

derecognised and the carrying amount of the loan

as gain/loss

Part of the loan which has been

extinguished

Do the change in terms result in a substantial

modification

Extinguish original liability and recognise a new liability at fair

value

Adjust carrying amount of the

original financial liability

Part of the loan which has been

modified

No

No

No

No

Yes

Yes

Yes

Yes



AnalysisTerm loan

As mentioned above, 60 per cent of the term loan liability has been extinguished and the remaining 40 per cent has been modified by extending the term by two years and reducing the interest rate for the remaining term to 6.5 per cent per annum. The company has issued 3.2 million equity shares (fair value of INR12.5 per share, i.e INR40 million) to the lender for restructuring the liability.

The equity shares are issued towards extinguishment of 60 per cent of the loan as well as modification of the terms for the remaining 40 per cent. While the aggregate fair value of the equity shares issued to the lender is INR40 million, the company is required to estimate the shares issued towards the portion of the loan that has been extinguished and the shares issued as consideration for modifying the terms of the remaining loan. This is determined with reference to the fair value of the portion of the loan that has been extinguished. The fair value of entire loan on the date of restructuring was INR55 million. Therefore, the fair value of the extinguished portion of the loan is INR33 million (INR55 million *60%). The carrying amount of the extinguished portion of the loan is INR36 million (INR60 million *60%). The company should recognise the following accounting impact on extinguishment of the loan as on 31 March 2017.

The balance equity shares, with a fair value of INR7 million (INR40 million – 33 million) are considered to have been issued as consideration towards modification of the remaining loan (carrying amount of INR24 million). The company is required to assess if the modification of terms of the remaining loan is substantial in order to determine if this portion should also be derecognised. This is determined by comparing the carrying amount of the remaining loan with the net present value of the modified cash flows (discounted at the original effective interest rate). This difference amounts to 19 per cent of the original carrying amount or amortised cost indicating that the modification is substantial.

The company should therefore derecognise this portion of the original loan liability and recognise a new financial liability at its fair value, i.e. INR17.15 million as mentioned above. The difference between the carrying amount and the consideration paid (fair value of equity shares issued and new loan liability) should be recognised in the statement of profit and loss as a modification gain or loss. The following is the accounting entry to be recognised on modification.


31 March 2017 On extinguishment of 60 per cent of the loanTerm loan liabilityEquityGain on extinguishment of loan (P&L)

Dr 36,000,000Cr 33,000,000Cr 3,000,000


31 March 2017 On modification of the remaining 40 per cent of the loanTerm loan liabilityLoss on modification EquityNew term loan liability

Dr 24,000,000Dr 150,000Cr 7,000,000Cr 17,150,000





Preference shares

In accordance with the original terms, the preference shares were cumulative and redeemable in nature and were therefore classified as a financial liability. Based on the revised terms the preference shares are non-redeemable with a discretionary dividend component and are mandatorily convertible into a fixed number of equity shares of the company. This indicates that the preference shares would be classified as an equity instrument of the company after the change in contractual terms.

The change in classification of the preference shares from a financial liability to an equity instrument due to a change in contractual terms is, in substance, an extinguishment of the financial liability by issue of equity instruments. Therefore, this should be accounted for on the basis of the guidance in Appendix D of Ind AS 109. The financial liability should be derecognised and the resulting gain or loss, being the difference between the carrying amount of the financial liability and the fair value of equity instruments issued should be recognised in profit or loss.

The carrying amount of the preference shares (financial liability) on the date of modification in terms is INR9,892,640 and the fair value of the preference shares (equity instruments) based on the amended contractual terms is INR11 million. The company should therefore recognise the following accounting entry.


31 March 2017 On amendment of the contractual terms of the preference sharesPreference share liabilityLoss on derecognitionEquity (preference shares)

Dr 9,892,640Dr 1,107,360Cr 11,000,000

Consider this….• In a debt for equity swap, identifying the part of the liability extinguished and

the part that remains outstanding (as well as allocation of consideration received to both) requires judgement. While a simple allocation method based on the change in the nominal amount of the financial liability may be appropriate in some circumstances, it could also lead to unreasonable results, particularly if the interest payable on the remaining portion of the loan has been increased.

• The guidance on derecognition of a financial liability, including the guidance on accounting for a debt for equity swap, would not apply to issuance of equity instruments to settle a financial liability in accordance with its original contractual terms. For example, conversion of a convertible bond into equity shares in accordance with the original conversion terms results in derecognition of the liability and recognition of the equity instrument at the carrying amount of the liability, with no gain or loss being recognised.

• Apart from a change in the contractual terms, reclassification between equity and financial liability may also arise on a change in the effective terms of an issued instrument. This may occur when certain contractual provisions become effective or cease to be effective due to factors such as the passage of time, occurrence of contingent events, change in the group structure of an entity, etc. The reclassification of an instrument from financial liability to equity due to a change in effective terms may be recognised by analogy to Appendix D of Ind AS 109 (similar to the accounting treatment of a debt for equity swap). Alternatively, the reclassification may be accounted in a manner similar to that of conversion of a convertible instrument in accordance with its original terms.



Accounting for low interest and interest-free loans

Ind AS 109, Financial Instruments requires all financial instruments to be recognised initially at their fair value, which is normally the transaction price. However, an entity may sometimes receive or give interest-free or low interest loans, e.g. inter-company loans received from parent/group entities, government loans or tax deferral schemes, subsidised loans to staff, etc.

To determine the fair value of such low-interest or interest-free loans, an entity should first assess whether the interest charged on the loan is at a below-market rate based on the terms and conditions of the loan, local industry practice and local market circumstances. The fair value of such loans is then determined in accordance with Ind AS 113, Fair Value Measurement.

In this case study, we analyse four types of financial instruments to determine if these are in the nature of low-interest or interest-free loans and analyse the appropriate recognition and measurement requirements under Ind AS.

Key characteristics of the financial instrumentsM Private Limited (the entity/company), operates in the industrial manufacturing sector and has entered into the following types of transactions during the quarter ended 30 September 2016.


Table 1: Key characteristics of the financial instruments

Particulars Amount (in INR) Additional information

Deferred sales tax liability (unsecured) 90,000,000 This represents the sales tax liability of the company for sales made during the quarter ended 30 September 2016. The company is covered under a sales tax deferral scheme which permits the company to pay its quarterly sales tax liability after a period of 10 years from the end of the quarter, with no interest being charged to the company during this term. The company is eligible for this scheme due to the nature of capital investment made by the company. The company would be able to borrow funds for a similar amount and term at an interest rate of 15 per cent per annum.

Unsecured, interest free loan received from ABC Private Limited on 1 August 2016 (immediate holding company of M Private Limited). There are no stated terms of repayment. However, M Private Limited is expected to repay the loan from funds generated from its business.

200,000,000 Market rate for a short-term loan, repayable on demand, is 11.5 per cent per annum.


Accounting issue Ind AS 109 requires all financial instruments to be initially recognised at their fair value. As mentioned earlier, this is normally evidenced by the transaction price. However, M Private Limited is required to identify loans that may be interest-free or low interest in nature and determine their fair value in accordance with Ind AS 113 on initial recognition.

The company is also required to determine if the difference between the amount lent/borrowed and the fair value qualifies for recognition as an asset or liability or whether it should be recognised as a gain or loss.

Accounting guidance Figure 1 illustrates the applicable guidance in Ind AS 109 for measuring financial instruments at fair value on initial recognition.


Table 1: Key characteristics of the financial instruments (continued)

Particulars Amount (in INR) Additional information

The company has extended an unsecured loan on 1 July 2016 (under its staff policies) to an employee at a nominal interest rate of 2 per cent per annum. This loan will be repayable over a period of 3 years (in equal instalments) or when the employee leaves the organisation, whichever is earlier.

600,000 The employee would be able to obtain a similar loan at a market rate of 14 per cent per annum.

The company has extended a loan to its subsidiary, XYZ Private Limited on 30 September 2016 at an interest rate of 5 per cent per annum. The loan is repayable after 5 years.

100,000,000 Unsecured loan of the same denomination, for the same period and at same terms would be extended by banks to XYZ Private Limited at an interest rate of 13 per cent per annum.


Does the transaction price represent fair value, i.e. is the interest charged at market rates?

Bifurcate the transaction price into two components

Fair value of the loan (within scope of Ind AS 109)

‘Other component’ (gain or loss unless it qualifies for recognition as an asset or liability)

Determine fair value under Ind AS 113

‘Other component’ recognised under relevant standard (based on relationship between borrower and lender)

Classification and subsequent measurement under Ind AS 109

Recognise loan at the transaction price

No

Yes



In determining whether a loan is offered at a below-market rate, the company should consider the following aspects:• All the terms and conditions of the

loan• Local market circumstances and the

industry practice• Interest rates currently charged by

or offered to the entity for loans with similar risks and characteristics.

Ind AS 113 defines fair value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. In determining fair value, Ind AS 113 requires an entity to maximise the use of quoted prices or other relevant

observable inputs. However, if these are not available, a valuation technique may also be used, such as a present value technique with inputs that include future cash flows and discount rates that reflect assumptions that market participants would apply in pricing the financial instrument.

Ind AS 109 requires the difference between the transaction price and the fair value of a low-interest or interest-free loan to be recognised as a gain or loss (if the fair value is based on observable inputs), unless it qualifies for recognition as an asset or liability. This normally depends on the relationship between the lender and borrower or the reason for providing the loan.

Analysis The loans received and given by M Private Limited in the illustration above would be considered as below market since they are not at market rates that would apply to a normal commercial arrangement between market participants.

Table 2 below summarises the accounting and measurement requirements for the low-interest/interest-free loans borrowed and lent by the company, based on the guidance above.

The following is an analysis of each of the financial instruments mentioned in the table above.

Deferred sales tax liabilityThe deferred sales tax liability is an incentive received by the company from the government under a sales tax deferral scheme. Since the loan is interest-free in nature, its face value or the transaction price is not considered to represent fair value. Therefore, the company is required to determine the fair value based on the guidance in Ind AS 113.

The company considers that the use of a present value technique based on the cash flows payable under the

scheme is an appropriate method of determining fair value. In order to determine the discount rate to be used, the company is required to assess the interest rate based on assumptions that market participants would use to price a liability with similar terms, risk exposures and characteristics as this loan. For the purpose of this illustration, this rate is determined on the basis of the company’s incremental borrowing rate (i.e. the rate at which the company would be able to borrow funds on similar terms from market participants in an arms’ length transaction) as 15 per cent per annum.

Using this rate to discount the cash flows payable by the company under the sales tax deferral scheme, the fair

value of the liability on 30 September 2016 is determined as INR22,229,593. The difference between the fair value of the loan and the amount payable is INR67,770,407. This represents the ‘other component’ which is considered to be in the nature of a government grant since it represents an incentive received by the company from the government. This should be accounted for in accordance with Ind AS 20, Accounting for Government Grants based on the terms of the scheme applicable to the company, and may be either deferred and amortised to the statement of profit and loss over the period of the sales tax deferral loan or recognised up front, as appropriate.

ParticularsBorrowings Loans given

Deferred sales tax liability

Loan taken from holding company

Employee loansLoan extended to

subsidiary

Face amount of the loan (in INR)

90,000,000 200,000,000 600,000 100,000,000

Approximate fair value of the loan initially recognised as per Ind AS 109 (in INR)

22,229,593 200,000,000 483,708 71,842,044

The ‘other than market terms’ element of the loan (in INR)

67,770,407 NIL 116,292 28,157,956

Nature of the ‘other than market terms’ element of the loan recognised by the company

Government grant N.A. Employee benefit expense

Investment in subsidiary

Table 2: Summarised analysis of the loans given and received




The company would have to accrue interest expense on the loan liability at the effective interest rate (being the discount rate used to determine initial fair value) over the term of the sales tax deferral loan.

Loan from parent The unsecured loan received by the company from its parent, ABC Private Limited, is also in the nature of an interest-free loan and should be recognised initially at its fair value. This loan has no fixed contractual cash flows or stated repayment terms. In order to determine the appropriate recognition and measurement requirements for this loan, the company may consider various factors, including whether:• Classification as a liability is

appropriate, i.e. whether there is a contractual obligation,

• There is any agreed means of repayment specified in the loan agreement or in a side agreement, or

• It is possible to estimate the timing of the loan repayments.

For the purpose of this illustration, the company is expected to repay this loan from available funds that are internally generated from its business. This indicates that the company has an obligation to repay this loan even though there is no specific repayment date, and it may be appropriately classified as a financial liability.

Since it is not practicable to estimate the timing of repayment of this loan (although the company is expected to have sufficient funds for repayment), this liability could be considered as repayable on demand by the lender, i.e. the parent company. In this scenario, Ind AS 113 states that ‘the fair value of a financial liability with a demand feature is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.’ Assuming that this loan is considered as repayable on demand at any time, no discounting would be required on initial recognition. Accordingly, the loan from the parent company would be measured by M

Private Limited at its face value, which is also its fair value.

However, a detailed analysis would be required on initial recognition to ascertain all the facts and circumstances related to this type of a loan to determine the expected repayment terms and the appropriate accounting treatment, including the need for discounting, if any. For example, if the loan has no fixed maturity date and is available in perpetuity, then its fair value would be measured by applying a present value/discounting technique that considered these terms.

Unsecured loan to employeeThe staff loan provided to an employee under the company’s policies is a low-interest loan that should be measured at its fair value on initial recognition. The use of a present value technique is considered as an appropriate method for determining fair value by the company.

As mentioned above, the discount rate is determined based on the guidance in Ind AS 113 using assumptions that market participants would use to price a financial asset with similar terms and characteristics. In this illustration, the discount rate is determined as 14 per cent per annum on the basis of the rate at which the employee would be able to obtain a similar loan from independent market participants.

Using this rate to discount the cash flows receivable by the company, the fair value of the loan asset on 1 July 2016 (date of initial recognition) is determined as INR483,708. The difference between the fair value of the loan and the amount lent, i.e. the ‘other component’ is INR116,292. This would be considered as an employee benefit provided by the company and should be generally recognised as an expense over the term of the loan.

The loan asset would generally be classified as measured at amortised cost and the company would be required to accrue interest income at the effective interest rate (i.e. the discount rate used to determine fair value) over the term of the loan.

Loan to subsidiaryThe 5 per cent, unsecured loan given by the company to its subsidiary is a low-interest loan that should be measured at fair value on initial recognition. The fair value is determined in a manner similar to that described above, using a present value technique. The appropriate discount rate is estimated as 13 per cent per annum, being the incremental borrowing rate of the subsidiary, XYZ Private Limited, i.e. the rate at which market participants would price a financial asset with similar terms and risk characteristics.

Using this discount rate, the fair value of the loan to the subsidiary is determined as INR71,842,044 on initial recognition as on 30 September 2016. The loan was provided by the company in its capacity as the major shareholder of XYZ Private Limited. Therefore, the difference of INR28,157,956 between the fair value and the amount lent, may be considered as an additional equity contribution by the company to its subsidiary. Accordingly, this amount would be recognised as an additional investment in the subsidiary in the separate financial statements of the company at the time of initial recognition of the loan.

The loan asset would generally be classified into the amortised cost category and the company would be required to subsequently accrue interest income at the effective interest rate (i.e. unwind the discount) over the five-year term of the loan.



Consider this….

• The measurement of fair value of a loan repayable on demand by the lender would be based on the perspective of an independent market participant acting in its economic best interest. Accordingly, the lender may also measure such a loan at its face value, being the amount repayable on demand.

• In the absence of stated repayment terms for an interest-free/low-interest loan between group companies, entities are required to apply judgement to determine if a loan may be classified as a financial liability or an equity instrument of the borrower. For example, a loan that is not repayable in perpetuity, where the borrower does not have access to any means of repayment, or repayment is at the discretion of the borrower, may not qualify for classification as a financial liability. A detailed analysis of the facts and circumstances surrounding the grant of the loan would be required in this scenario to determine the appropriate classification as well as measurement for the loan.

• On fair valuation of an interest-free loan from a parent to a subsidiary, the ‘other component’ being the difference between the fair value and the face value of the loan may be considered as an equity infusion by the parent. Conversely, the difference between fair value and face value of an interest-free loan provided by a subsidiary to its parent, could be considered as a distribution/return of capital by the subsidiary to the parent entity, based on an analysis of relevant facts and circumstances.




Classification and measurement


Classification of investments in preference shares

Ind AS 109, Financial Instruments establishes principles for the classification of financial assets into various categories and their subsequent measurement on this basis.

Ind AS 109 broadly requires all financial assets to be categorised based on the business model in which they are held and their contractual characteristics into those measured at:

• Amortised cost

• Fair Value through Profit or Loss (FVTPL), or

• Fair Value through Other Comprehensive Income (FVOCI)

In this case study, we analyse three types of preference shares to determine the appropriate measurement category for classification by their holder under Ind AS 109.

Key terms of the preference sharesCompany A holds certain investments in preference shares (as described in table below). The objective of the business model within which these instruments are held is to hold these preference shares until maturity in order to collect their contractual cash flows.

Company A is required to classify each of these investments on initial recognition in accordance with the guidance in Ind AS 109.

Accounting issueInd AS 109 requires company A to classify its financial assets as subsequently measured at amortised cost, FVOCI or FVTPL on the basis of both:

• Its business model for managing the financial assets, and• The contractual cash flow characteristics of the financial asset.


Contractual features

Cumulative Redeemable Preference Share (CPS)

Non-cumulative Redeemable Preference Share (NCPS)

Optionally Convertible Preference Share (OCPS)

Term 5 years 5 years 5 years

Face value INR1,000 each INR1,000 each INR1,000 each

Redemption Redeemable at the end of its term

Redeemable at the end of its term

Redeemable at the end of its term

Dividend Mandatory dividend of 10 per cent per annum, cumulative in nature

Non-cumulative dividend of 11 per cent per annum, payable if dividends are to be paid on ordinary shares

Mandatory dividend of 5 per cent per annum, cumulative in nature

Conversion Non-convertible Non-convertible Each OCPS is convertible at the option of the holder into 5 ordinary shares of the issuer at any time prior to maturity



Accounting guidanceThe following is an illustration of the relevant guidance in Ind AS 109 for classification of the preference shares.

Does the preference share (in its entirety) meet the definition of an equity

instrument (Ind AS 32)?

Is the preference share held for trading?

Has the preference share been irrevocably categorised as FVOCI?

FVOCI Equity FVTPL FVOCI Debt Amortised cost

Are the preference share’s contractual cash flows solely payments of principal

and interest (SPPI)?

Are the preference shares held in a business model whose objective is ‘hold

to collect contractual cash flows’?

Are the preference shares held in a business model whose objective is

achieved by both collecting contractual cash flows and selling financial assets?

No

No

No

Yes Yes

No No

No

Yes

Yes

Yes

Yes

Figure 1: Classification of financial assets in accordance with Ind AS 109

Our analysisThe preference shares held by company are analysed on the basis of the guidance above for classification under Ind AS 109 in Table 1 below.

Criteria CPS NCPS OCPS

Does the instrument meet the definition of an ‘equity’ instrument under Ind AS 32?

No(Redeemable with mandatory distributions)

No(Redeemable principal amount)

No(Redeemable if holder does not opt to convert)

Are the contractual cash flows SPPI?

Yes(Principal repayment and cumulative distributions representative of interest cash flows)

No(Non-cumulative, discretionary nature of distributions is inconsistent with SPPI)

No(Option to convert into equity shares is inconsistent with SPPI)

Are the preference shares ‘held to collect’?

Yes NA(Since SPPI is not met)

NA(Since SPPI is not met)

Classification under Ind AS 109

Amortised cost FVTPL FVTPL

Table 1: Classification of preference shares under Ind AS 109

Source: Insights into IFRS, KPMG IFRG Ltd’s publication, 13th edition, September 2016




Consider this….• An instrument that is mandatorily redeemable in cash and that does not meet the

definition of an equity instrument may still be classified and measured at fair value through profit or loss if it does not meet either of the criteria for amortised cost measurement.

• Any feature that results in an interest cash flow that is inconsistent with a basic lending arrangement (representing payment for time value of money) may result in an investment in a debt instrument being ineligible for classification into the amortised cost category. For example, leveraged interest payments, interest payments linked to an inflation index of a currency other than that in which the instrument is issued, or interest payments linked to an equity index.

• Financial assets that are hybrid or compound in nature are assessed for classification in their entirety and are not split into their components. Accordingly, such instruments generally may not qualify for classification into the amortised cost category.

CPSThe CPS are debt instruments and are analysed on the basis of the SPPI and ‘business model’ criteria in order to determine their classification under Ind AS 109.

• The contractual cash flows of the CPS are the repayment of principal and mandatory dividends which are cumulative in nature. The dividends represent an ‘interest’ element as they are consideration for the time value of money payable by the issuer of the CPS. The CPS is also redeemable on maturity, which represents a payment of principal. There are no other contractual cash flows or features that require consideration for classification of this instrument. This indicates that the CPS meets the SPPI criteria.

• As stated in the illustration above, company A holds the CPS within a business model whose objective is to collect contractual cash flows arising from investments over their term. Therefore, the ‘business model test’ is also met.

In accordance with the guidance in Ind AS 109, the CPS qualify for classification into the amortised cost category as the conditions specified for such classification are met.

NCPSThe NCPS does not meet the definition of an equity instrument since the principal amount is mandatorily redeemable on maturity. Hence, it cannot be classified as FVOCI (equity). It can be classified as measured at amortised cost or FVOCI (debt) only if it meets the relevant SPPI and business model criteria, or else is classified as measured at FVTPL.

• The NCPS is mandatorily redeemable at maturity, indicating that one of its contractual cash flows is payment of principal. However, the dividend payments are discretionary as well non-cumulative in nature. This indicates that they do not represent consideration for time value of money for the holder. Hence, the SPPI criterion is not met.

• The NCPS are held within a business model whose objective is to hold the investments to collect their contractual cash flows.

Since the NCPS do not meet the SPPI criterion, they do not qualify for being subsequently measured at amortised cost. Hence, the NCPS should be classified as and subsequently measured at FVTPL.

OCPSThe OCPS does not meet the definition of an equity instrument since the principal amount is redeemable in the event that company A does not exercise the option to convert the OCPS into a fixed number of shares. Therefore it cannot be classified as FVOCI (equity).

The mandatory redemption at maturity is a contractual cash flow that represents a payment of principal. However, the conversion feature is in the nature of an equity return that may flow to company A, and does not represent either a payment of principal or interest. This indicates that the SPPI criterion is not met.

While the OCPS may be held within a business model that has a ‘hold to collect’ objective, they do not qualify for classification into the amortised cost category as they do not meet the SPPI criterion. Therefore, the OCPS should be classified as and subsequently measured at FVTPL.


Classification of investments in mutual funds

In the previous case study, we described the guidance in Ind AS 109, Financial Instruments, relevant to classification of investments in preference shares. While the same guidance applies to classification of investments in mutual funds, there are additional application issues to consider. In this case study, we analyse these issues for investments in three types of mutual funds to determine their classification under Ind AS 109.


Key terms of investments in mutual fundsCompany A provides IT services to clients and invests its surplus funds in the following instruments.

Company A is required to classify each of these investments on initial recognition in accordance with the guidance in Ind AS 109.

Diversified equity mutual fund Liquid fund Fixed Maturity Plan (FMP)

Objective Long-term investment of surplus funds

Short-term investment to manage liquidity needs

Medium term investment to generate fixed returns

RedemptionOpen-ended scheme, redemption permitted at any time

Open-ended debt scheme, redemption permitted at any time

Close-ended debt scheme with a fixed maturity date at the end of 3 years (redemption not permitted prior to maturity). Can be traded on an exchange

Dividends

None - The mutual fund is a growth fund and is expected to generate returns through capital appreciation

Dividends are paid by the fund based on its performance

The FMP expects to generate a yield of 9 per cent per annum

Business model Not ‘held to collect’ Held to collect dividends and for

sale Held to collect until maturity

Underlying investments of the fund

Equity shares – these may be traded frequently by the fund house to generate returns

Short-term money market instruments (commercial paper, certificate of deposit, treasury bills) – may be traded to generate returns

Fixed income instruments (corporate bonds, government securities, commercial paper) with matching maturities – these are all held until maturity



Accounting issueInd AS 109 requires company A to classify its financial assets as subsequently measured at amortised cost, FVOCI or FVTPL on the basis of both:

• Its business model for managing the financial assets, and

• The contractual cash flow characteristics of the financial asset.

Accounting guidanceFigure 1 is an illustration of the relevant guidance in Ind AS 109 for classification of investments.

AnalysisDoes the mutual fund meet the definition of an equity instrument?

Ind AS 109 permits an entity to make an irrevocable choice to present changes in the fair value of an investment in an equity instrument in Other Comprehensive Income (OCI). However, this option is available only if the equity investment is neither ‘held for trading’ nor is in the nature of contingent consideration recognised by an acquirer in a business combination to which Ind AS 103, Business Combinations applies. Accordingly, company A would be permitted to select this measurement option if its investments in mutual fund units are in the nature of qualifying equity instruments.

The term ‘equity instrument’ is defined from the perspective of the issuer in Ind AS 32, Financial Instruments: Presentation as ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’. Further, a financial liability is defined as ‘any liability that is a contractual obligation to deliver cash or another financial asset to another entity’. Based on these, a unit issued by a mutual fund or an FMP would not meet the definition of an equity instrument since the issuer (the fund) has a contractual obligation to redeem the instrument either at the option of the holder (for open-ended schemes) or at maturity (for close-ended plans). While Ind AS 32 has a specific exception for classifying puttable instruments

(those that give the holder the right to put the instrument back to the issuer for cash or another financial asset) as equity in certain circumstances, these instruments still are not considered to meet the definition of an equity instrument for the purpose of the FVOCI election. This interpretation is consistent with the Basis for Conclusions to International Financial Reporting Standard (IFRS) 9, Financial Instruments which is applicable internationally.

Consequently, these investments cannot be designated as FVOCI and are to be classified based on the relevant guidance illustrated in Figure 1.

Does the instrument (in its entirety) meet the definition of an equity instrument (Ind AS 32)?

Is the instrument held for trading?

Has the instrument been irrevocably categorised as FVOCI?

FVOCI Equity FVOCI DebtFVTPL Amortised cost

Are the instrument’s contractual cash flows Solely Payments of Principal and Interest (SPPI)?

Are the instruments held in a business model whose objective is - hold to collect contractual

cash flows?

Are the instruments held in a business model whose objective is achieved by both collecting con-

tractual cash flows and selling financial assets?

No

No No

No

No

No

Yes Yes

Yes

Yes

Yes Yes




Diversified equity mutual fund

This investment is classified as FVTPL since there are no contractually specified cash flows and hence the SPPI criterion is not met. The amount receivable by the holder on redemption or sale shall be based on the fair value of the underlying investments held by the fund in equity instruments.

Liquid fund

While the investment held in the liquid fund yields returns in the form of dividends and is also redeemable by the holder for cash, further analysis is required to determine its classification. In addition to assessing the cash flows generated by the instrument, Ind AS 109 requires the holder to ‘look through’ to the underlying investments that ultimately generate the cash flows in a scenario where the returns on an investment are contractually linked to underlying assets. In this case, the investments held by the liquid fund are all debt instruments which generate cash flows that represent payments

of principal and interest. However, the liquid fund has the discretion to sell its investments in order to optimise returns. Therefore, the cash flows paid by the fund to the unit holder comprise gains/losses on the debt instruments held by the fund, in addition to interest and principal cash flows from those instruments. Consequently, the SPPI criterion is not met.

While the investment in the liquid fund is held by company A within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, the investment cannot be classified as FVOCI since the SPPI criterion is not met. Hence, company A should classify this investment as FVTPL.

FMP

In the illustration above, the FMP that company A has invested in is a close-ended scheme with no redemptions permitted until maturity. Further, the underlying instruments that the FMP invests in are all debt instruments that

give rise to contractual cash flows that are in the nature of solely principal and interest payments. The FMP invests in debt instruments with maturities that match the payments to be made by the FMP to its unit holders, and also generally holds these investments until their maturity. This indicates that the SPPI criterion is met for this investment.

Further, the investment in the FMP is held by company A within a business model whose objective is to hold investments to collect their contractual cash flows.

These factors indicate that company A’s investment in the FMP could qualify for classification into the ‘amortised cost’ category. This classification is based on a detailed analysis of facts and circumstances, including ‘looking through’ to the underlying investments made by the FMP and a restriction on the fund’s ability to buy/sell/trade investments. In the absence of such restriction FVTPL treatment would be required.


Table 1: Classification of financial assets in accordance with Ind AS 109

Classification of investments – analysis

Our analysis for classification of the investments in funds is summarised in the table below.

CriteriaDiversified equity mutual fund

Liquid fund FMP

Does the instrument meet the definition of an ‘equity’ instrument under Ind AS 32

No (Redeemable at the option of the holder)

No(Redeemable at the option of the holder)

No(Redeemable at maturity)

Are the contractual cash flows SPPI?

No(Redemption amount represents capital appreciation in investment based on return generated by underlying equity investments)

No(Redemption amount represents composite return earned on underlying investments which may include gains/losses on sale)

Yes(FMP pays a return that is based on contractual cash flows of its underlying debt investments, that meet SPPI)

Are the instruments held within a ‘held to collect’ business model?

No No Yes

Are the instruments held within a business model that has a dual objective of holding to collect and for sale?

No Yes No

Classification under Ind AS 109 FVTPL FVTPL Amortised cost



Consider this….• Although a puttable financial instrument such as a unit issued by a fund may qualify for

classification as ‘equity’ from the perspective of the issuer under the exception provided in Ind AS 32, it does not meet the definition of an equity instrument since the issuer has a contractual obligation to pay the holder. Consequently, the irrevocable option to classify and measure equity investments at FVOCI would not be available to such investments, which would therefore be classified and measured at FVTPL.

• Investments in a debt mutual fund do not necessarily meet the SPPI criterion even though the fund invests in debt instruments with contractual cash flows that are solely payments of principal and interest. The fund may periodically churn its investment portfolio and hence the return paid by the fund to its unit holders is also based on gains or losses on sale of investments. Therefore, the units in the fund held by the investor may not give rise to contractual cash flows that meet the SPPI criterion.

• While the investment in the FMP in the illustration above may qualify for classification and measurement at amortised cost, each investment should be assessed based on its specific facts and circumstances. This may include ‘looking through’ to the underlying investments when the cash flows are contractually linked to such instruments and restrictions on the fund manager’s ability to buy/sell/trade such investments.

• On transition to Ind AS, companies that have significant investments in mutual funds that are classified as FVTPL, are required to recognise the cumulative fair value change, if any, as an adjustment to equity (retained earnings). This amount represents the fair value change in the investments up to the transition date and would not be subsequently reclassified into the statement of profit or loss or reflected in the earnings per share (EPS), even on disposal of the investments.


Analysis of business model to determine classification of financial assets

Entities are required to consider the business model within which they hold financial assets in order to determine their classification, i.e. amortised cost, Fair Value through Other Comprehensive Income (FVOCI), or Fair Value through Profit or Loss (FVTPL), on initial recognition.

Indian Accounting Standard (Ind AS) 109, Financial Instruments permits financial assets to be classified as measured at ‘amortised cost’ only if:

• Their contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (SPPI), and

• They are held within a business model whose objective is to hold assets to collect contractual cash flows (held to collect).

In this case study, we illustrate some of the considerations relating to analysing the business model within which an entity holds a portfolio of investments.

Key characteristics of investmentsR Limited (the company or the entity), a large engineering and construction company, is required to invest funds in multiple ongoing projects. The company has prepared an expenditure budget for a period of five years (which approximates the operating cycle of its projects) and revises it on an annual basis to determine the funds required for its projects. The company has a treasury department which invests surplus funds and manages its funding/liquidity requirements by investing in a suitable portfolio of investments. As on 1 January 2017, the company acquired the following investments:

• 7 per cent 10 year government securities for INR10 million

• 9 per cent three year bonds issued by X Limited for INR5 million.



The employees in the treasury department receive variable incentive payments on the basis of the yield generated on government securities and corporate bonds as well as the profits earned on sale of corporate bonds.

Accounting issueThe company is required to determine the objective of the business model within which the investments acquired as on 1 January 2017 would be held. Accordingly, the company is required to classify the acquired investments on initial recognition into one of the following three categories:

• Fair Value Through Profit or Loss (FVTPL) – investments that are not held within a ‘held to collect’ business model or those that do not meet SPPI

• Fair Value Through Other Comprehensive Income (FVOCI) – investments held within a business model that has a dual objective (held to collect and for sale) and that meet SPPI

• Amortised cost – investments that are held within a ‘held to collect’ business model and that meet SPPI.


Investments Government securities Corporate bonds

Carrying amount of investments INR300 million INR200 million

Period for which the company intends to hold the investment

The management intends to hold its investments in government securities until maturity

The company intends to hold the corporate bonds to maximise yield but may also sell to profit from a fall in interest rates

Objective of the business model

The treasury department invests in government bonds with long-term maturities that match its liquidity needs (in accordance with its expenditure budgets).

The company invests in corporate bonds in order to benefit from higher yields and also earn profits from sales of corporate bonds in a falling interest rate scenario. Bonds may be sold based on the medium term funding requirements of the company as well as to earn profits based on changes in bond prices.

Current assessment of business model Held to collect Dual objective – held to collect and for sale

Past trend

The company generally holds government securities until maturity and has negligible instances of sales from this portfolio. However, in the previous quarter, the company secured two new infrastructure projects that were not originally part of its expenditure budget. In order to obtain the funds required to commence these projects, the company sold government securities of INR25 million before maturity. The entity has aligned its subsequent investments to the liquidity needs of the new projects and has revised its expenditure budget.

In the past, the entity invested in high-yield corporate bonds in order to maximise its investment returns. The maturities of the corporate bonds were generally longer than the company’s medium-term funding requirements. Therefore, the company sold a portion of its corporate bond portfolio to fund expenditure on capital projects.

Over the past six months, the company has also sold over 50 per cent of its corporate bonds portfolio in order to benefit from increasing bond prices. The company now intends to actively maximise profits by trading in corporate bonds to benefit from volatility in bond prices.

SPPI criteria The investments in government securities meet SPPI criteria

The investments in corporate bonds meet SPPI criteria

The company also held the following investments in government securities and corporate bonds as on 1 January 2017.



Accounting guidanceFinancial assets, such as the government and corporate bonds above, that meet the SPPI criteria (debt investments) may be classified into one of three categories on the basis of the business model within which they are held. Figure 1 illustrates the effect of the business model on classification of bonds:

Figure 1: Impact of business model on classification of financial assets

The assessment of the business model is generally at an aggregated or portfolio level. Although it requires judgement, the analysis is based on fact and not management intent (expressed at a security level), and should consider all relevant information, including:

• The way in which the performance of the portfolio is evaluated and information is reported to key management personnel

• How managers of the business/portfolio are compensated, i.e. on the basis of contractual cash flows or fair value of assets managed

• The frequency, volume and timing of sales in prior periods, including the reasons for such sales and expectations about future sales activity. Sales may be consistent with a ‘held to collect’ business model in certain scenarios. For example, if sales occur due to an increase in the

credit risk or close to the maturity of the financial asset. Additionally, sales that are either infrequent or insignificant (individually and in aggregate) in nature may also be consistent with a ‘held to collect’ business model.

AnalysisGovernment securities

The company has invested in government securities to meet its long-term liquidity needs. The maturities of the investments are aligned to the company’s budgeted expenditure on its projects. Further, the company has infrequent instances of sales that have occurred from its portfolio of government securities in the past. These factors indicate that the government securities are held within a business model whose objective is met by holding the investments to collect their contractual cash flows.

However, an instance of a significant sale in the past quarter may require further analysis. The company has sold securities worth INR25 million to meet an unexpected capital expenditure on new projects won in the previous year. Although the sale is not individually insignificant (relative to the aggregate portfolio of INR325 million, including the investments sold), it appears to be infrequent in nature. Similar sales are not expected to occur in the future since investments have been aligned to the revised budget.

Therefore, the business model for the portfolio of government securities may continue to be assessed as ‘held to collect’. The company should classify the government securities acquired as on 1 January 2017 into the amortised cost category since they meet both the SPPI and business model criteria.

Are the bonds’ contractual cash flows solely pay-ments of principal and interest (SPPI)?

Are the bonds held in a business model whose objec-tive is ‘hold to collect contractual cash flows’?

Are the bonds held in a business model whose objec-tive is achieved by both collecting contractual cash

flows and selling financial assets?

FVOCI Debt Amortised costFVTPL


No

No

No

Yes

Yes

Yes



Corporate bonds

The company invests in corporate bonds to improve its returns on investments by generating higher yields on corporate bonds to offset the low interest rates earned on investments in government securities. Since the maturities of the corporate bonds were sometimes longer than the timing of the funds required, the company had several instances of sales in the past to meet the funding requirements for incurring capital expenditure. The company also sold bonds to earn profits by taking advantage of increasing bond prices. Based on these factors, the company had previously assessed that the corporate bonds were held within a business model that had a dual objective, i.e. collecting contractual cash flows as well as for sale.

The company should now assess the impact of increasing sales over the past six months from the corporate bond portfolio. The sale of approximately 50 per cent of the bonds portfolio in several transactions over six months may be considered as both frequent as well as significant in aggregate. Further, the company now intends to maximise gains by actively trading in corporate bonds in the future due to increasing volatility in bond prices. While this would not affect the classification of the existing investments in the portfolio, it may require a reassessment of the business model for new investments. Figure 2 below illustrates the relevant considerations in Ind AS 109:

As explained in Figure 2, the entity should not change the business model under which it manages its existing investments. However, while classifying the new investment in corporate bonds of X Ltd, acquired on 1 January 2017, it should reassess the business model if it considers that the investments are no longer managed in a manner consistent with a dual objective (held-to-collect and for sale). Given that the company expects to actively trade in the corporate bonds going forward, the new investment may require to be classified as at FVTPL.

Figure 2: Reassessment of business model

Are cash flows realised in a way different from the entity’s expectation?

No reassessment required

Remaining financial assets held in that business model

Newly orginated/purchased financial assets

No change in classification Reassess business model


Yes

No



Consider this….

• If, in the case study above, the company sold the corporate bonds due to an increase in their credit risk based on the credit policy of the company, then, the company may have been able to conclude that the sales were consistent with a ‘held to collect’ business model. This is because the credit quality of financial assets is considered relevant to the company’s ability to collect contractual cash flows.



Application of effective interest method

Financial assets and liabilities that are classified as ‘amortised cost’ are subsequently measured using the effective interest rate method under Indian Accounting Standard (Ind AS) 109, Financial Instruments. In addition, financial assets (excluding equity instruments) that are classified into the ‘Fair Value through Other Comprehensive Income (FVOCI)’ category may also require the application of the Effective Interest Rate (EIR) method for recognition of interest income.

Ind AS 109 defines the EIR method as the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability.

In this case study, we aim to illustrate the application of the EIR method to a financial liability measured at amortised cost and a financial asset classified as FVOCI.

Key terms of financial instrumentsZ Limited (the company), currently in the process of building a port in India, has entered into the following transactions on 1 April 2016:

Preference shares issued Corporate bonds acquired

Description 1,000,000, 5 per cent cumulative preference shares of INR100 each, issued at par (INR100,000,000)

5,000 10 per cent corporate bonds acquired for INR1,000 each (INR5,000,000)

Transaction costs

INR1,000,000 on legal and professional fees N.A.

Redemption Redeemable by the company at the end of 3 years at a premium of 20 per cent (i.e. redemption amount is INR120,000,000)

Redeemable by the issuer at the end of 5 years at face value being INR1,200 per bond (i.e. redemption amount is INR6,000,000)

Dividends/interest

5 per cent per annum 10 per cent per annum

Business model

N.A. Held to collect and for sale (the company has acquired these investments for temporarily investing surplus funds. These bonds may be sold to fund capital expenditure in the future)

Ind AS 109 classification

Financial liability at amortised cost Financial asset at FVOCI

Fair value at 31 March 2017

N.A. INR1,100 per bond

This illustration does not include the impact of expected loss assessment on the investment in corporate bonds.

Accounting issueInd AS 109 requires the company to recognise interest expenses/income in accordance with the EIR method. The financial liability (preference shares) is subsequently measured at amortised cost and the financial asset (investment in corporate bonds) is subsequently measured at FVOCI. The analysis in this case study illustrates the computation of the EIR and its application in accounting for these financial instruments.



Accounting guidanceFigure 1 illustrates the guidance in Ind AS 109 on the elements forming part of the calculation of amortised cost:

Financial assets

Amount initially recognised

Principal repayments

Cumulative amortisation, using the EIR of any difference between the initial amount and the maturity amount

Gross carrying amount

Loss allowance

Amortised cost Amortised cost (no adjustment for loss allowance)

Minus

Plus or minus

Equals

Minus

Equals

Financial liabilities

Analysis

Preference shares - financial liabilityOn initial recognition, a financial asset or financial liability that is not classified as FVTPL is measured at its fair value plus or minus directly attributable and incremental transaction costs. The fair value on initial recognition is generally equal to the transaction price, i.e. the fair value of consideration given or received for the financial instrument. Therefore, the preference share liability is initially recognised at INR99 million (INR100 million – INR1 million).

The preference share liability is classified as measured at amortised cost, which is calculated on the basis of the EIR method. This method is used for amortising premiums, discounts and transaction costs. The EIR is calculated on initial recognition and is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument, to the gross carrying amount of a financial asset or the amortised cost of a financial liability.

In the case of the preference share liability, its amortised cost on initial recognition is equal to its fair value, adjusted for transaction costs, i.e. INR99 million. The expected cash payments include the annual interest payments at 5 per cent per annum (INR5 million payable annually) and the redemption amount including the redemption premium (INR120 million).




Corporate bonds – financial asset

The investment in corporate bonds is in the nature of a debt instrument, which is classified as FVOCI by Z Limited. Therefore, gains or losses are recognised in OCI, except for the following items, which are to be recognised in the statement of profit and loss (similar to the recognition requirements for financial assets measured at amortised cost):

• Interest revenue measured using the EIR method,

• Expected credit losses or reversals, and

• Foreign exchange gains or losses, if any.

On derecognition of the financial asset, the cumulative gain or loss recognised in OCI is reclassified to profit or loss.

In determining the EIR for a financial asset, all contractual terms of the instrument are considered other than expected credit losses. This is since the interest revenue is measured on the basis of contractual terms and is independent of the expected credit loss estimates.

The corporate bonds are initially recognised at their fair value (equal to the transaction price), being INR5 million. The expected cash receipts include the annual interest coupon of 10 per cent per annum (INR600,000 per annum) and the redemption proceeds of INR6 million at the end of five years. Based on these, the EIR for this financial asset is computed as 14.92 per cent per annum.

Date Interest expense (in INR)(Amortised cost*11.37% p.a.)

Cash inflows/(outflows)(in INR)

Amortised cost (in INR)(Opening amortised cost+Interest expense-Cash outflows)

1 April 2016 99,000,000 99,000,000

31 March 2017 11,260,852 (5,000,000) 105,260,852

31 March 2018 11,972,998 (5,000,000) 112,233,850

31 March 2019 12,766,150 (125,000,000) Nil


1 April 2016 On initial recognition of the financial liability, net of transaction costs

BankPreference share liability

Dr 99,000,000Cr 99,000,000

31 March 2017 Accrual of interest expense and payment of dividend

Interest expensePreference share liabilityBank

Dr 11,260,852Cr 6,260,852Cr 5,000,000

Based on these, the EIR for this liability is computed as 11.37 per cent per annum. The following table illustrates the computation of interest expense and amortised cost based on the EIR.

The difference between the accrued interest expense and the dividend paid represents the amortisation of the transaction costs and the redemption premium on the preference share liability. The following are the accounting entries that should be recognised by Z Limited for the preference share liability for the year ended 31 March 2017.





Particulars Amount in INR

Initial carrying amount of the corporate bonds at 1 April 2016

Add: Interest income accrued in the profit or loss at the EIR of 14.92 per cent

Less: Interest coupon received by the entity

Amortised cost of the corporate bonds as at 31 March 2017

5,000,000

746,166

(600,000)

5,146,166

Fair value of the corporate bonds at 31 March 2017 (INR1,100 per bond)

Amortised cost of the bonds

Cumulative fair value change (gain) recognised in OCI

5,500,000

5,146,166

353,834


1 April 2016 On initial recognition of the investment

Investment in corporate bonds (FVOCI debt)Bank

Dr 5,000,000Cr 5,000,000

31 March 2017 Accrual of interest income, receipt of interest coupon and recognition of fair value changes

BankInvestment in corporate bondsInterest income (profit or loss)Fair value gain on corporate bonds (OCI)

Dr 600,000Dr 500,000Cr 746,166Cr 353,834

The following table illustrates the accounting impact for the first year, including the computation of amortised cost and the amounts recognised in profit or loss/OCI. The impact of expected credit losses has been ignored for the purpose of this illustration.

The interest income accrued in profit or loss includes the amortisation of the difference between the amount initially recognised and the redemption amount.

The following are the accounting entries that should be recorded by Z Limited in respect of the corporate bonds for the year ended 31 March 2017.





Consider this….• A financial liability that has been issued at a low or nil interest rate but carried a

substantial redemption premium will affect the statement of profit and loss as the redemption premium will be accrued over the life of the instrument at the EIR. Companies that have such financial liabilities outstanding at the date of transition to Ind AS are required to retrospectively compute the amortised cost of the liability and recognise the unamortised premium in the form of interest expense over the remaining term.

• A financial asset, being a debt instrument, classified as FVOCI will still have an impact on the statement of profit and loss for accrual of interest income on the basis of the EIR, recognition of expected losses and foreign exchange differences, if any. Further, the fair value change recognised in OCI is reclassified into the profit or loss on derecognition of such financial asset unlike fair value gains or losses on investments in equity instruments that are irrevocably classified as FVOCI.


Impairment of financial assets


Impairment assessment for trade receivables

Indian Accounting Standard (Ind AS) 109, Financial Instruments requires the recognition of an impairment loss allowance for expected credit losses on a financial asset (being a debt instrument) that is measured at amortised cost or fair value through other comprehensive income (FVOCI).

The general approach to impairment assessment under Ind AS 109 requires the loss allowance to be measured at an amount equal to 12-month expected credit losses for financial instruments where the credit risk has not increased significantly since initial recognition. For those financial instruments where the credit risk has increased significantly, the loss allowance is measured at an amount equal to lifetime expected credit losses.

However, Ind AS 109 also provides a simplified approach to measure impairment losses on trade receivables, lease receivables and specific contractual rights to receive cash/another financial asset. This case study illustrates a method that may be used by an entity to apply the simplified approach to measure impairment losses on trade receivables.

Key characteristics of the trade receivables

An Indian company, M Limited, manufactures office equipment and has a portfolio of trade receivables of INR461 million at its half-yearly reporting date, 30 September 2016. M Ltd supplies

equipment nationally to a large number of small clients. Its past experience indicates that loss patterns on its trade receivables differ based on the region in which its customers are located. Further, receivables that have been outstanding for more than one year have historically been uncollectable and result in a loss being incurred, irrespective of the region in which they originate. The outstanding amount of trade receivables for each region is as follows:


Region Trade receivables at 30 September 2016 (in INR million)

Impairment allowance as at 30 June 2016 (in INR million)

North 137 2.85

South 98 1.80

East 74 1.50

West 152 3.00

Total 461 9.15

M Limited monitors the current and expected economic scenario on an ongoing basis and categorises it as stable, improving or worsening in nature. When preparing its business forecasts for the next financial year, M Limited has obtained information that suggests that the domestic economic environment is likely to worsen, specifically for businesses operating in the western region.

Accounting issue

Ind AS 109 requires an entity, at each reporting date, to measure and recognise a loss allowance for expected credit losses on all financial assets. The assessment of expected credit losses should be based on reasonable and supportable forward-looking information that is available without any undue cost or effort. M Limited is preparing its

interim financial statements for the half-year ended 30 September 2016 and is therefore required to assess impairment on its portfolio of trade receivables under Ind AS 109.



Accounting guidance

Figure 1 illustrates the guidance on impairment in Ind AS 109.


Is the asset credit impaired at initial recognition?

Is the asset a trade receivable or a contractual right to receive cash or another financial asset (arising under Ind AS 11 or 18)?

Is the asset a lease receivable for which the entity has elected to measure impairment based on lifetime expected credit

losses?

Has there been a significant increase in credit risk since initial recognition?

Recognise 12-month expected credit losses

Recognise changes in lifetime expected credit losses

Recognise lifetime expected credit losses

No

Yes

Yes

Yes

Yes

No

No

No

Ind AS 109 permits the use of practical expedients for measurement of expected credit losses if they are in compliance with the general principles, i.e. result in measurement of expected credit losses in a way that reflects:

• An unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes,

• The time value of money, and

• Reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current

conditions and forecasts of future economic conditions.

Ind AS 109 provides an example of a practical expedient – a provision matrix – for calculation of expected credit losses on trade receivables. A provision matrix may generally have the following features:

• It is based on historical credit loss experience, adjusted as appropriate to reflect current conditions and reasonable and supportable forecasts of future economic conditions,

• It might specify provision rates based on the number of days that a trade receivable is past due, and

• Appropriate grouping or segmentation may be used if the historical experience shows different loss patterns for different customer segments, e.g., geographical region, customer rating, product type, etc.



Analysis

M Limited uses the provision matrix as a practical expedient to measure expected credit losses on its portfolio of trade receivables as at 30 September 2016. Based on its historical experience, it segments its receivables based on the geographical region to which its customers belong.

Table 1 provides the ageing of M Limited’s trade receivables for the western region, at 30 September 2016 and as at the past 10 quarterly interim reporting dates. Receivables that are more than one year old are considered uncollectable. This illustration is based on the assumption that the trade receivables have a short duration and do not carry a contractual interest rate. Therefore, the effective interest rate of these receivables is considered to be zero and discounting of expected cash shortfalls has not been performed.

Table 1: Historical ageing of trade receivables held by M Limited (in INR million)


Reporting date Balance Not due 0-90 days 90-180 days 180-270

days 270-360

days More than 360 days

September-16 152.00 86.00 42.00 18.50 3.00 2.00 0.50

June-16 144.00 81.00 48.00 9.00 4.00 1.00 1.00

March-16 116.00 69.00 29.00 10.60 4.00 2.00 0.40

December-15 117.00 60.00 35.00 15.30 5.00 1.00 0.70

September-15 96.00 44.00 32.00 15.30 3.00 1.50 0.20

June-15 136.00 76.00 40.00 13.00 4.60 2.00 0.40

March-15 164.00 91.00 53.00 12.30 5.00 2.00 0.70

December-14 160.00 94.00 48.00 12.00 3.50 1.50 1.00

September-14 151.00 79.00 56.00 9.00 4.50 2.20 0.30

June-14 147.00 72.00 59.00 9.00 5.70 1.00 0.30

March-14 150.00 85.00 47.00 11.00 4.50 2.00 0.50



A provision matrix is developed by M Limited to compute the historical observed default rates. These are determined by computing the historical ‘flow rate’ of trade receivables, based on their ageing and arriving at an average loss rate. This is demonstrated in Table 2 below:

Reporting date Not due 0-90 days 90-180 days 180-270 days 270-360 days More than

360 days

September-16 56.58% 51.85% 38.54% 33.33% 50.00% 50.00%

June-16 56.25% 69.57% 31.03% 37.74% 25.00% 50.00%

March-16 59.48% 48.33% 30.29% 26.14% 40.00% 40.00%

December-15 51.28% 79.55% 47.81% 32.68% 33.33% 46.67%

September-15 45.83% 42.11% 38.25% 23.08% 32.61% 10.00%

June-15 55.88% 43.96% 24.53% 37.40% 40.00% 20.00%

March-15 55.49% 56.38% 25.63% 41.67% 57.14% 46.67%

December-14 58.75% 60.76% 21.43% 38.89% 33.33% 45.45%

September-14 52.32% 77.78% 15.25% 50.00% 38.60% 30.00%

June-14 48.98% 69.41% 19.15% 51.82% 22.22% 15.00%

March-14

Average 54.08% 59.97% 29.19% 37.27% 37.22% 35.38%

Table 2: Computation of ‘flow rate’ based on historical ageing of trade receivable

The flow rate indicates the percentage of trade receivables in an ageing bracket that have not been collected during the quarter and have therefore moved into the next ageing bracket. For example, INR85 million of trade receivables were not due as at 31 March 2014. Of these, INR59 million were not collected during the following quarter and moved into the 0-90 days ageing bracket as at 30 June 2014. Therefore, the flow rate for the 0-90 days ageing bracket at 30 June 2014 is 69.41 per cent (59/85*100). The flow rate for all ageing brackets has been computed in this manner. Accordingly, M Limited has determined the historical average flow rates for all ageing brackets.

These average flow rates are then used to determine the credit loss rate (determined as a product of the average flow rates for the applicable ageing brackets) to be applied to the trade receivables as at 30 September 2016. This loss rate is adjusted by a forward-looking estimate that includes the probability of a worsening domestic economic environment in the western region over the next few quarters. The computation of the credit loss rate and the expected credit loss amount is illustrated in table 3.




For example, of the INR86 million receivables that are currently not due, 59.97 per cent is expected to move into the 0-90 days bracket. 29.19 per cent of the receivables in the 0-90 days bracket are expected to move into the 90-180 days ageing bracket, and so on. The credit loss rate computed in table 3 above is a product of the flow rates for the applicable ageing brackets. The adjusted credit loss rate includes the forward-looking estimate to reflect the probability of worsening economic

conditions. The adjusted credit loss rate has been computed by applying an increase of approximately 5 per cent to the historical credit loss rate for all ageing brackets. Using this method, the total expected credit loss on the portfolio of trade receivables as at 30 September 2016 is measured as INR4.01 million.

M Limited is required to measure its total impairment allowance on trade receivables on 30 September 2016 at INR4.01 million. At 30 June 2016,

the impairment allowance for trade receivables for the western region was INR3 million. Therefore, the additional impairment loss to be recognised in the statement of profit and loss for the quarter ended 30 September 2016 is INR1.01 million.

M Limited should perform a similar analysis to compute the expected credit loss for trade receivables for the other three regions.

Ageing bracket

Balance (INR

million)

0-90 days

90-180 days

180-270 days

270-360 days

More than 360

days

Not collected

Credit Loss Rate

Adjusted credit

loss rate

ECL (INR million)

Not due 86.00 59.97% 29.19% 37.27% 37.22% 35.38% 100.00% 0.86% 0.90% 0.77

00-90 days 42.00 29.19% 37.27% 37.22% 35.38% 100.00% 1.43% 1.50% 0.63

90-180 days 18.50 37.27% 37.22% 35.38% 100.00% 4.91% 5.15% 0.95

180-270 days 3.00 37.22% 35.38% 100.00% 13.17% 13.80% 0.42

270-360 days 2.00 35.38% 100.00% 35.38% 37.00% 0.74

More than 360 days

0.50 100.00% 100.00% 100.00% 0.50

Total 152.00 4.01

Table 3: Credit loss rate and impairment loss computation




Consider this….

• Trade receivables generally have a short duration and do not carry a contractual interest rate. Therefore, they are measured on initial recognition at the transaction price. Accordingly, the effective interest rate for trade receivables is considered to be zero and discounting of expected cash shortfalls to reflect the time value of money would not be required when measuring expected credit losses. However, companies should consider the impact of any financing element in the trade receivables which may have to be separated at initial recognition, especially once Ind AS 115, Revenue from Contracts with Customers becomes applicable.

• The use of historical loss experience to determine lifetime expected credit losses is permitted as a practical expedient under Ind AS 109. However, companies are required to adjust data based on their credit loss experience on the basis of current observable data to reflect the effects of current conditions and forecasts of future conditions. Further, information about historical credit loss rates should be applied to groups of receivables that are consistent with groups for which the historical loss rates were observed.


`


`Financial Instruments: Application issues under Ind AS 78

Hedge accounting


Hedging foreign currency risk on forecast transactions

Ind AS 109, Financial Instruments permits an entity to apply hedge accounting in order to represent the effect of its risk management activities in its financial statements. Hedge accounting is voluntary and may be applied to individual transactions or a group of similar transactions if they meet the qualifying criteria specified in the standard.

Ind AS 109 envisages the following three types of hedging relationships:

• Fair value hedge: A hedge of the exposure to changes in the fair value of a recognised asset or liability or an unrecognised firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss or other comprehensive income (OCI) (for a hedge of an equity investment measured at fair value through OCI).

• Cash flow hedge: A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all of, or a component of, a recognised asset or liability or a

highly probable forecast transaction, and could affect profit or loss.

• Net investment hedge: A hedge of the foreign currency exposure arising from a net investment in a foreign operation, as defined in Ind AS 21, The effects of changes in foreign exchange rates, when the net assets of that foreign operation are translated for inclusion in the consolidated financial statements.

This case study highlights the qualifying criteria for hedge accounting as prescribed by Ind AS 109.It analyses its applicability to a hedge of foreign currency risk and determines the accounting treatment for such transaction.

Key terms of the financial instruments

Company A (the entity/company) is a manufacturer of fragrances and imports certain essential raw materials that are used in manufacturing its finished products. Approximately 95 per cent of the imports of the company are made

in US Dollars (USD). Considering the volume of foreign exchange transactions and the fluctuation in the USD-INR exchange rates, the entity has identified foreign currency risk as a key financial risk. In accordance with its documented risk management policies, the company hedges its foreign currency exposure using USD-INR forward contracts. A hedge is considered to be effective under the policy if it offsets the variability in the cash flows on the imports within a range of 90-110 per cent.

On 1 March 2017, the company has hedged a highly probable forecast foreign currency purchase of USD 4,280,000, expected to be delivered on 15 May 2017, by entering into a forward contract to buy USD 4,280,000 on 31 May 2017 at a forward rate of INR67.53. The forward contract has been transacted with a reputed banking institution. Further, company A is itself a highly-rated, investment grade entity. The following are the forward rates applicable during the period of the transaction:


Date USD/INR spot rateUSD/INR forward

rate for 31 May 2017 maturity

USD/INR forward rate 15 May 2017

maturity

MTM ((gain)/loss) on forward contract

(INR)

1 March 2017 66.58 67.53 67.22 -

31 March 2017 66.90 67.70 67.35 (727,600)

15 May 2017 67.44 67.82 67.44 (1,241,200)

31 May 2017 68.21 68.21 NA (1,669,200)

(Note: Time value of money has been ignored for the purpose of this illustration)



Accounting issue

Ind AS 109 requires the entity to classify and measure the forward contract (derivative instrument) at fair value through profit or loss (FVTPL). This gives rise to an accounting mismatch and creates volatility in the statement of profit and loss since the corresponding hedged transactions are not recognised until the company receives delivery of the raw materials.

While hedge accounting is not mandatory under Ind AS 109, it may be applied to mitigate the accounting mismatch if the hedge relationship meets the qualifying criteria. The company is required to analyse the underlying transaction, including the relationship between the hedged item (forecast imports in USD) and the hedging instrument (forward contract) to evaluate if hedge accounting may be applied.

Accounting guidance

The forward contract has been acquired to mitigate the variability in cash flows arising from exposure to foreign currency risk on the forecast import transaction. The company is required to evaluate if it can designate and account for this hedge relationship as a cash flow hedge under Ind AS 109. Figure 1 below illustrates the qualifying criteria to be met in order to apply hedge accounting to this hedging relationship.

Figure 1: Qualifying criteria for applying hedge accounting under Ind AS 109


Is there a qualifying hedged item and hedging instrument?

Is the hedging relationship consistent with the entity’s risk management obective?

Is there an economic relationship between the hedged item and the hedging instrument?

Does the effect of the credit risk dominate the fair value changes?

Does the hedge ratio (based on actual quantities used for risk management) reflect an imbalance that would create hedge

ineffectiveness?

The entity is permitted to apply hedge accounting(Ensure formal designation and documentation)

Hedge accounting cannot be applied• Measure the hedging instrument at

FVTPL• Measure the hedged item based on

applicable Ind AS

Yes

No

Yes

No

No

Yes

Yes

Yes

No

No



Analysis

Ind AS 109 requires all derivatives to be classified as and measured at FVTPL, giving rise to volatility in profit and loss on each reporting date until maturity of the forward contract. Since the underlying hedged item is a forecast purchase in foreign currency, it does not affect the statement of profit and loss until the transaction occurs, i.e. until the material is delivered. If company A elects to not apply the hedge accounting principles in Ind AS 109, the accounting mismatch in the timing of the impact on the statement of profit and loss will remain.

Qualifying criteria

The company may therefore apply hedge accounting to mitigate this accounting mismatch provided the transactions meet the qualifying criteria under Ind AS 109, as indicated below:

• The USD/INR forward contract is a derivative transacted with an external party. Therefore, this is a qualifying hedging instrument.

• As mentioned above, the hedged item is a ‘highly probably’ forecast purchase in USD that gives rise to foreign currency risk. The transaction may be considered as ‘highly probable’ based on an analysis of facts and circumstances that includes consideration of the extent and frequency of similar transactions in the past (past trends), quality of the budgeting process (for planned purchases and production), availability of adequate resources to complete the transaction, etc. Therefore, this would be considered to be a qualifying hedged item.

• The entity has identified foreign currency risk as a key financial risk and has documented risk management policies relating to the use of forward contracts to hedge this risk.

• The forward contract to buy USD offsets the foreign currency risk arising from the USD obligation on the forecast purchase contract, thus indicating an economic relationship between the hedged item and

hedging instrument. However, the maturity date of the forward contract is 31 May 2017 and the forecast purchase is expected to occur on 15 May 2017, indicating that the critical terms of the transactions are closely aligned but do not completely match (as there would be a difference in the forward rates for the two maturity dates). The company would therefore need to use a quantitative method to establish that this hedging relationship is expected to be highly effective over the hedging period.

• The company may also consider excluding the forward element of the derivative contract from the hedging relationship and designate only the spot element (i.e. changes in spot rates as the hedged risk) in order to prevent the forward element from affecting hedge effectiveness. Under this approach, the forward element may be separately accounted for as a ‘cost of hedging’ based on the guidance in Ind AS 109.

• The forward contract has been transacted with a highly rated banking institution. Company A is itself also an investment grade entity based on external credit ratings. Hence, it may be expected that the effect of credit risk would not dominate the fair value changes.

• The notional amounts of the forward contract and the forecast purchase transaction are identical indicating a hedge ratio of 1:1. Therefore, the hedge ratio does not reflect an imbalance that would give rise to hedge ineffectiveness.

The analysis above indicates that this hedging relationship meets the qualifying criteria.

Hedge designation and effectiveness

The company has elected to exclude the forward element and designate only the change in spot element of the forward contract as the hedging instrument in a cash flow hedge of foreign currency risk on the forecast purchase. The forward element represents the difference between the forward price

and the current spot price (on the date of entering into the contract) of the underlying exposure. The forward element would therefore be separately accounted for as a cost of hedging. This is illustrated separately in this case study.

The company may measure hedge effectiveness using the hypothetical derivative method. Under this method, the hedged item is defined as a hypothetical derivate with critical terms that exactly match the forecast purchase transaction, i.e. the hedged item would be a forward contract to purchase USD, maturing on 15 May 2017. Since the notional amounts of the forecast purchase transaction and the forward contract are the same, the hedge ratio is 1:1. The change in the fair value of the forward contract would exactly offset the change in the fair value of the hedged item, based on changes in spot rates (being the designated risk). Therefore, the hedge relationship is expected to be highly effective in nature and the company may apply cash flow hedge accounting.

Cost of hedging

When the forward element of a forward contract is separated and excluded from the designated hedging instrument, Ind AS 109 requires the change in fair value of such excluded portion to be either recognised at FVTPL or accounted for as a cost of hedging. The company has elected to apply the ‘cost of hedging’ approach when recognising the excluded forward element. Ind AS 109 requires this element to be divided into two parts:

• Aligned component – the component of the forward element that relates to the hedged item based on critical terms that exactly match the hedged item. This would be the forward premium for a maturity date of 15 May 2017 in the illustration above.

• Remaining component – this is the remaining portion of the forward element that does not relate to the hedged item, i.e. the difference between the forward premium for a 31 May 2017 maturity date and a 15 May 2017 maturity date.



Cash flow hedge accounting

The company would apply the cash flow hedge accounting model to this hedge relationship. Accordingly, the designated portion (i.e. spot element) and the excluded portion (i.e. forward element) of the forward contract would be accounted as illustrated in figure 2 below:

• The effective portion of the change in fair value of the hedging instrument due to a change in spot rates (100 per cent in this illustration) is recognised in a cash flow hedging reserve, which is a component of other comprehensive income (OCI).

• Hedge ineffectiveness, being the portion of change in the fair value of the hedging instrument that does not offset changes in the hedged item (nil, in this illustration) is recognised in the statement of profit and loss.

• Since the hedged forecast purchase results in the recognition of a non-financial asset, i.e. inventory, the accumulated effective component is removed from the cash flow hedging

reserve and included in the initial cost of the inventory, when the purchase is recognised.

• The aligned component of the cost of hedging is accumulated in a separate component of equity (cost of hedging reserve) and the remaining component is recognised in profit or loss.

• The accumulated cost of hedging is recognised in the initial cost of inventory since the hedged item is a transaction that results in recognition of a non-financial asset.

Figure 2: Application of hedge accounting


Change in fair value of spot element of forward contract

Effective component in Cash flow hedge reserve (OCI)

Transfer to initial cost of non-financial asset (inventory)

Aligned component (based on critical terms match) in

cost of hedging reserve (OCI)

Transfer to initial cost of non-financial asset (inventory)

Ineffective component in profit or loss

Remaining component of excluded portion in profit or

loss

Change in fair value of forward element of forward contract

Total change in fair value of forward contract



Accounting entries

The following are the illustrative accounting entries for the example above (the effect of time value has been ignored for the purpose of this illustration).

The following table indicates the accounting impact for each component (the effect of time value has been ignored for the purpose of this illustration).

Date

FV of forward contract

(A)

FV change in spot element

(B)

FV change in excluded element

(C)#

FV change in aligned component

(D)##

FV change in remaining component

(E)

(change in forward rates*notional)

(change in spot rates*notional)

(change in forward premium*notional)

(change in forward premium*notional)

(C-D)

01-March-17 - - - - -

31-March-17 727,600 (1,369,600) 642,000 813,200 (171,200)

15-May-17 513,600 (2,311,200) 1,797,600 1,926,000 (128,400)

31-May-17 **1,669,200 - - - -

**Hedge accounting would cease on occurrence of the forecast purchase transaction on 15 May 2017# Forward premium of the forward contracts maturing on 31 May 2017 has been considered.## Forward premium of the hypothetical derivative maturing on 15 May 2017 has been considered.Source: KPMG in India’s analysis, 2017


1 March 2017 No entry for entering into forward contract as the fair value of the forward contract is nil.No entry for payables/purchases since the procurement/payment will be made in the future.

31 March 2017 Hedge accounting impact at reporting dateDerivative accountCost of hedging reserve- OCI (aligned forward component)Cash flow hedge reserve- OCI (spot element)Profit and loss (remaining forward component)(Recognised change in spot element in the cash flow hedge reserve in accordance with cash flow hedge accounting and change in fair value of the aligned forward element in a separate component of equity)

Dr 727,600Dr 813,200Cr 1,369,600Cr 171,200

15 May 2017 Hedge accounting impact on date of purchaseDerivative accountCost of hedging reserve- OCI (aligned forward component)Cash flow hedge reserve- OCI (spot element)Profit and loss (remaining forward component)(Recognised incremental change in spot element in the cash flow hedge reserve in accordance with cash flow hedge accounting and incremental change in fair value of the aligned forward element in a separate component of equity)

Dr 513,600Dr 1,926,000Cr 2,311,200Cr 128,400

15 May 2017 Actual purchasesPurchases/inventoryTrade payables(Recognition of purchases at spot rate as on 15 May 2017.)

Dr 288,643,200Cr 288,643,200




15 May 2017 Recycling cumulative gain/loss to cost of inventory on termination of hedge accountingCash flow hedge reserveCost of hedging reserve Inventory(Hedge accounting is terminated on occurrence of the hedged item, i.e. the purchase)

Dr 3,680,800Cr 2,739,200Cr 941,600

31 May 2017 Fair valuation of forward contract Derivative accountProfit and loss(Incremental change in fair value of the forward contract recognised in profit and loss.)

Settlement of derivative contractBankDerivative account(Net settlement of the forward contract on maturity)

Dr 1,669,200Cr 1,669,200

Dr 2,910,400Cr 2,910,400

Consider this….

• The effectiveness of a hedging relationship should be determined at the inception of the hedging relationship as well as on an ongoing basis. At a minimum, this assessment is required at each reporting date, or on a significant change in the critical terms, or in circumstances affecting the hedge effectiveness requirements. Where any of the criteria for hedge accounting is no longer met, hedge accounting must be discontinued prospectively.

• If the company had elected to designate the entire forward contract (including forward element) as the hedging instrument, the hedge relationship may have been ineffective based on the effectiveness range of 90 to 110 per cent required as per the entity’s risk management policy. The exclusion of the forward element enables the company to improve the hedge effectiveness ratio and designate this as a qualifying hedging relationship.




Hedge accounting using cross currency interest rate swaps

Entities that borrow funds at floating rates in foreign currency are exposed to market risks arising from changes in interest and foreign exchange rates. Companies in India often mitigate these risks by entering into a fixed to floating cross currency interest rate swap (CCIRS).

A fixed to floating CCIRS (as typically used in India) is in effect a combination of two swaps:

• A principal only swap- in which principal cash flows in two different currencies are exchanged to hedge against adverse movements in exchange rates

• A coupon only swap- to exchange a series of floating rate coupons in a foreign currency for a series of fixed rate coupons in the entity’s desired currency to hedge changes in interest rates and exchange rates.

By entering into a CCIRS agreement, two parties undertake to exchange nominal and interest payments in two currencies periodically.

In this case study, we analyse how a CCIRS may qualify as a hedging instrument and illustrate the applicable accounting treatment.


On 1 July 2016, A Limited (the company or the entity) obtained a three-year, USD10,000,000 loan from bank X that is repayable on 30 June 2019. The interest rate on the loan is variable at 6-month LIBOR plus 2.75 per cent per annum, payable on a half yearly basis (on 31 December and 30 June each year). Concerned that interest and foreign exchange rates may increase, A Limited simultaneously (on 1 July 2016) enters into a three year cross currency principal cum interest rate swap (CCIRS or the swap) with bank Y. Details of the transaction are as follows:

Swap start date 1 July 2016

Underlying exposure ECB from bank X

Notional amount USD10,000,000

Maturity date 30 June 2019

Fixed exchange of principal at maturity A Limited receives USD10,000,000 and pays INR660,000,000 to bank Y on maturity

Interest payment frequency Half-yearly

Interest hedge

USD floating rate payer

Bank Y pays: USD 6-month LIBOR + 2.75% p.a. on outstanding notional amount

INR fixed rate payer

A Limited pays: 10.5% p.a. on outstanding INR notional on a half yearly basis (on 31 December and 30 June each year) This includes a currency basis spread* of 0.5%p.a.

Settlement Net settlement

* The currency basis spread represents the liquidity premium/discount that an entity is exposed to when borrowing/transacting in foreign currencies that is not explained by a theoretical interest rate parity computation.




Accounting issue

The company needs to evaluate whether the CCIRS qualifies as a hedging instrument and whether the transaction meets the qualifying criteria to apply hedge accounting. The company also needs to determine the appropriate accounting treatment for the swap for the year ended 31 March 2017.

Accounting guidance and analysis

Qualifying criteria

Although CCIRS are complex instruments, they may qualify for hedge accounting if they meet the qualifying criteria and the company has ensured that it appropriately identifies and documents the hedge relationship at inception. Figure 1 below analyses the CCIRS based on the qualifying criteria for applying hedge accounting. The analysis indicates that the hedge relationship would meet the qualifying criteria in Ind AS 109 and is therefore eligible for hedge accounting.

The 6-month LIBOR rates and foreign exchange rates prevailing during the period are as follows:

The fair value of the interest rate swap at the end of each reporting period is as follows (the changes in fair value have been assumed for the purpose of this illustration):

Dates Total variable rate of interest (i) Spot exchange rate(ii)

1 July 2016 1.24% 66.00

31 December 2016 1.31% 68.20

31 March 2017 1.33% 67.00

Dates Fair value of CCIRS (Amount in INR) Fair value of hypothetical derivative (Amount in INR)

1 July 2016 Nil n/a

31 December 2016 84,858,895 78,206,573

31 March 2017 88,421,515 81,336,554



Figure 1: Qualifying criteria for applying hedge accounting under Ind AS 109


* The effect of credit risk on the fair value of the hedged loan as well as the fair value of the swap should be considered to measure hedge effectiveness, although it has been assumed as immaterial for the purpose of this illustration.

Is there a qualifying hedged item and hedging instrument?

Is there an economic relationship between the hedged item and the hedging

instrument?

Is the hedging relationship consistent with the entity’s risk management obective?

Does the effect of the credit risk dominate the fair value changes?

Does the hedge ratio (based on actual quantities used for risk management) reflect an imbalance that would create

hedge ineffectiveness?

The entity is permitted to apply hedge accounting

(Ensure formal designation and documentation)

Hedge accounting cannot be applied(Measure derivative hedging instrument at

FVTPL)

Yes

Yes

No

No

No

No

Guidance Analysis

No

Yes

Yes

Yes

Yes - the swap is with an external counterparty and the hedged risks affect

profit or loss

Yes - hedging of currency and interest rate risk is based on company’s

risk management policies

Yes - the critical terms of the swap are closely aligned to the foreign currency

loan and offset the risks

No - bank Y and the company are highly rated entities (investment grade)*

No - the hedge ratio is 1:1 as the notional amounts of the swap and the loan

match



For foreign currency loans received prior to the beginning of its first Ind AS reporting period, i.e. outstanding as on 1 April 2016, the company might have availed of the provisions in paragraph 46 or 46A of AS 11, The effects of changes in foreign exchange rates. These provisions permitted capitalisation of the exchange differences on translation of the loan into the cost of a related asset, or accumulation in a Foreign Currency Monetary Item Translation Difference Account (FCMITDA). The company may then elect to continue this accounting treatment for the existing loans under Ind AS, as permitted by Ind AS 101, First-time adoption of Ind AS. Consequently, under Ind AS, the translation differences on the existing loans would then continue to be capitalised into the related asset, or accumulated in FCMITDA and subsequently amortised over the life of the loan.

The principles of Ind AS 109 seem to permit designating these loans as a hedged item in a hedge of foreign currency risk, since the translation differences ultimately affect profit or loss in the form of depreciation or amortisation of FCMITDA. This is supported by guidance in Ind AS 109 that considers a scenario where cash flow hedge accounting is applied to a hedge of the foreign currency risk arising from a highly probable forecast transaction to acquire a non-financial asset (e.g., plant and equipment). If the hedged forecast transaction subsequently results in the recognition of a non-financial asset, then Ind AS 109 states that the entity should remove the accumulated amount from cash flow hedge reserve and include it directly in the initial cost or carrying amount of the asset.

However, this issue was considered by the Ind AS Transition Facilitation Group (ITFG). In its third bulletin, the ITFG opined that an entity that avails of the option available under Ind AS 101, and continues to capitalise (to the cost of the related asset) the foreign exchange differences arising from a long-term foreign currency loan, has no corresponding foreign currency exposure (arising from that loan) that affects profit or loss. Accordingly, hedge accounting under Ind AS 109 will not be applicable for foreign currency swaps transacted to hedge the foreign currency risk of such foreign currency loans. Companies should therefore carefully evaluate these transactions on first-time adoption of Ind AS and monitor further developments in this area.

Hedge designation

The company may elect to designate the entire CCIRS as a hedge of the variability in cash flows relating to interest payments on and principal repayment of the foreign currency borrowing (the hedged item), arising from fluctuation in the floating interest rates and foreign exchange rates.

Considering that the CCIRS involves exchange of a stream of cash flows in two different currencies, it generally includes a foreign currency basis spread. Since there is no similar spread in the hedged item (i.e. the foreign currency loan), the basis spread is expected to give rise to some ineffectiveness. Ind AS 109 permits the company to exclude the currency basis spread from the hedge relationship and recognise it separately

as a ‘cost of hedging’. However, the company has not elected to do so and has designated the entire swap as the hedging instrument.

The hedged item would be represented by a hypothetical derivative in order to measure effectiveness and compute ineffectiveness using the hypothetical derivative method. The hypothetical derivative is defined so that it matches the critical terms of the hedged item.

In this case study, the critical terms of the hypothetical derivative would be similar to the actual CCIRS, however, the swap rate (interest rate payable) on the hypothetical derivative would exclude the currency basis spread of 0.5 per cent. This is expected to give rise to some ineffectiveness. The company has used a quantitative method to

analyse the prospective effectiveness of the hedge relationship and expects the changes in the fair value of the swap to offset the changes in the fair value of the loan (represented by the hypothetical derivative) in the range of 90 to 110 per cent. This is within the desired effectiveness range specified in the company’s financial risk management policies.



Cash flow hedge accounting

The company has hedged the variability in the cash flows of the loan due to changes in currency and interest rates. Therefore, it should apply the cash flow hedge accounting model to this hedge relationship. The accounting treatment for the transaction would be as illustrated in Figure 2 below:

The effective portion of changes in fair value of the hedging instrument is recognised in a separate component of equity ‘the cash flow hedging reserve’. The ineffective portion of the gain or loss on the hedging instrument (to the extent of movement in the currency basis spread, computed as the difference between the change in fair value of the CCIRS and the change in fair value of the hypothetical derivative) would be recognised in the statement of profit and loss.

The following table indicates the accounting impact for the swap (the changes in fair value have been assumed and the effect of time value has been ignored for the purpose of this illustration):

Figure 2: Cash flow hedge accounting for the swap

Hedging instrument


Amounts in INR

Critical terms matching with the hedged item

Basis spread

Effective portion of the hedging instrument

Ineffective portion of the hedging instrument

Change in fair value transferred to OCI

Reclassify amount corresponding to translation differences to profit

or loss

Reclassify amount corresponding to net settlement (interest) to

profit or loss

Change in fair value charged to profit or loss

DateVariable interest rate

Swap rate

Spot exchange rate

Gross payment made/accrued as per the swap(10,000,000*fixed exchange rate*swap rate)

Gross amount received/accrued as per the swap

(10,000,000*spot rate*floating interest rate)

Net pay/accrual as per the swap

(Gross pay - Gross received)

1 July 16 3.99% 10.5% 66 – – Nil

31 December 16 4.06% 10.5% 68.2 34,650,000 13,844,600 20,805,400

31 March 17 4.08% 10.5% 67 17,325,000 6,834,000 10,491,000




Accounting entries

The following are the illustrative accounting entries for the example above (the effect of time value has been ignored for the purpose of this illustration).


1 July 2016 BankExternal commercial borrowing(ECB of USD 10,000,000 at a floating interest rate of 6-month LIBOR + 2.75% taken from bank X. The spot rate on that date is INR66 per USD, hence the loan has been translated at the spot rate.)

No entry for entering into CCIRS as the fair value of the swap is Nil.

Dr 660,000,000Cr 660,000,000

31 December 2016

Interest expense on borrowingBank(Record floating interest rate on foreign currency borrowing)

Cash flow hedge reserve (OCI)Net finance cost (ineffective portion of the cash flow hedge)CCIRS (Balance sheet)(To recognise incremental change in fair value of CCIRS: INR84,858,895 – Nil. The effective portion is accumulated in OCI and the ineffective portion is recognised in the statement of profit and loss.)

CCIRS (Balance sheet)Bank(Net settlement of CCIRS interest exchange)

Interest expense on borrowingCash flow hedge reserve (OCI)(Reclassified from hedging reserve to reflect that interest expense has been fixed)

Foreign exchange loss on borrowing (profit or loss)External commercial borrowing(Recognise foreign exchange loss on borrowing: USD 10,000,000*(68.2-66))

Cash flow hedge reserve (OCI)Foreign exchange gain (profit or loss)(Since the currency risk on principal repayment is hedged, an amount equal to the translation loss on the loan is reclassified from the hedging reserve to offset spot re-measurement of the borrowing)

Dr 13,844,600Cr 13,844,600

Dr 78,206,573Dr 6,652,322Cr 84,858,895

Dr 20,805,400Cr 20,805,400

Dr 20,805,400Cr 20,805,400

Dr 22,000,000Cr 22,000,000

Dr 22,000,000Cr 22,000,000

31 March 2017 Cash flow hedge reserve (OCI)Net finance cost (ineffective portion of the cash flow hedge)CCIRS (Balance sheet)(To recognise change in fair value of CCIRS: INR88,421,515 – 84,858,895- the effective portion is accumulated in OCI and the ineffective portion is recognised in the statement of profit and loss.)

External commercial borrowing Foreign exchange gain on borrowing (profit or loss)(Recognise foreign exchange gain on borrowing: USD 10,000,000*(67-68.2))

Foreign exchange loss (profit or loss)Cash flow hedge reserve (OCI)(Since the currency risk on principal repayment is hedged, an amount equal to the translation loss on the loan is reclassified from the hedging reserve to offset spot re-measurement of the borrowing)

Interest expense on borrowingAccrued interest payable on borrowing(Accrue the interest on foreign currency loan for 3 months ended 31 March 2017)

Interest expense on borrowingCash flow hedge reserve (OCI)(Reclassified from hedging reserve to reflect that interest expense has been fixed)

Dr 3,129,981Dr 432,639Cr 3,562,620

Dr 12,000,000Cr 12,000,000

Dr 12,000,000Cr 12,000,000

Dr 6,834,000Cr 6,834,000

Dr 10,491,000Cr 10,491,000




Consider this….

• The ineffectiveness arising as a result of the currency basis spread may be mitigated by excluding this element from the hedging relationship. The company may then recognise this as a cost of hedging and accumulate the amount in a separate component of reserves. This cost of hedging, on a time-period related item is amortised into the statement of profit or loss over the period of the swap.

• A receive-fixed pay-floating interest rate swap may be designated as a fair value hedge of a fixed interest liability or as a cash flow hedge of a variable interest asset. An interest rate swap cannot be designated as a cash flow hedge of a fixed interest liability because it converts known (fixed) interest cash outflows, for which there is no exposure to variability in cash flows, into unknown (variable) interest cash outflows. Similarly, the swap cannot be designated as a fair value hedge of a variable interest asset because a variable interest instrument is not generally exposed to changes in fair value arising from changes in market interest rates.


Financial Instruments: Disclosures


Frequently Asked Questions (FAQs) on disclosure of financial instruments

Ind AS 107, Financial Instruments: Disclosures prescribes disclosures to be presented by an entity in its financial statements. Such disclosures enable users to evaluate the significance of financial instruments to the entity’s financial position and performance, the nature and extent of risks arising therefrom during the period and at the end of the reporting period, and how it manages those risks.

In these FAQs, we highlight some of the methods and techniques that may be used in preparing the disclosures on financial instruments. The disclosures illustrated in this article are only representative in nature and additional disclosures may have to be presented to comply with the requirements of Ind AS 107.

Fair value

Q 1. Company A has the following financial instruments outstanding as on 31 March 2017:

• A working capital loan from XYZ bank of INR50 million which is repayable in December 2017, the interest rate is reset on a monthly basis.

• Trade receivables amounting to INR1.5 million; and

• Trade payables of INR0.9 million.

What are the fair value disclosure requirements for these instruments?

A. Ind AS 113, Fair Value Measurement requires company A to measure and disclose the fair value of the financial instruments held at the reporting date. In addition, the company is required to categorise and disclose the fair value in accordance with the fair value hierarchy on the basis of the inputs used to measure fair value.

The working capital loan is classified and subsequently measured in the financial statements at amortised cost. Considering that the interest rate on the loan is reset on a monthly basis, the carrying amount of the loan would be a reasonable approximation of its fair value.

Similarly, the carrying amount of trade receivables and trade payables, which are classified and subsequently measured at amortised cost, approximate the fair values of these instruments due to their short-term nature.

Ind AS 107 provides relief to entities from disclosing the fair value of an instrument whose carrying amount is a reasonable approximation of its fair value. Accordingly, company A is not required to separately disclose the fair values of the working capital loan, the trade receivables and trade payables. Company A may provide a note as part of its fair value disclosure, stating that the carrying amounts of the instruments approximate their fair value.

Q 2. On 1 April 2016, company A borrowed USD 10.4 million (INR690 million) at a floating interest rate of 6-month LIBOR + 3 per cent per annum repayable on 31 March 2019. The LIBOR is reset on a half yearly basis on 31 March and 30 September each year. The financial performance of company A has improved in the previous year, which is reflected in a better credit rating. As on 31 March 2017, floating foreign currency loans, with a similar remaining term to maturity were available from other financial institutions at the rate of 6-month LIBOR + 2.5 per cent per annum to entities with an equivalent credit rating. The 6-month LIBOR as on 31 March 2017 is 1.3 per cent per annum and the carrying amount of the loan is INR685 million. What are the considerations for the fair value disclosures relating to the loan and at what level would it be categorised in the fair value hierarchy?

A. The fair value of a floating rate loan may be considered to approximate its carrying amount, assuming credit spread remains constant. However, as a result of an improvement in its credit rating, the company would be able to borrow funds with similar contractual characteristics at a lower rate of interest (based on a lower credit spread). Therefore, the discount rate to be used in computing the fair value of the loan should be the applicable market rate, based on the revised credit spread. The future cash flows payable on the loan may be estimated using the 6-month LIBOR forward curve and the forward exchange rates applicable on the contractual payment dates. The fair value of the foreign currency loan would be determined by discounting the estimated future cash flows at the market rate of return (i.e. 6-month LIBOR + 2.5 per cent). The computation is given below:




Date6-month LIBOR*

Interest rate (per annum)

Forward (USD-INR) exchange rate*

Cash outflow(INR in millions)

Discounting factor (6-month LIBOR + 2.5%)

Net present value (INR in millions)

30 September 2017 1.33% 4.33% 69.60 15.67 0.982 15.39

31 March 2018 1.58% 4.58% 69.81 15.83 0.964 16.03

30 September 2018 1.83% 4.83% 70.10 15.97 0.947 16.67

31 March 2019 2.08% 5.08% 71.22 756.98 0.929 706.27

Fair value 754.36

* For the purpose of this illustration, the 6-month LIBOR forward curve and the forward exchange rates have been assumed.

As per Ind AS 113, company A should disclose the valuation technique and inputs used to compute the fair value, and may consider providing a note as follows:

‘The valuation model adopted for computing the fair value of the borrowing is the discounted cash flow model, where the present value of expected payments is discounted using a market interest rate.’

Considering that the forward rates and the discount rate used for measuring fair value are market observable inputs, the foreign currency loan may be categorised as Level 2 in the fair value hierarchy disclosure.

Q 3. On 1 April 2016, company X fully acquired ABC Ltd by issuing its own shares to the vendor. The company also agreed to pay additional contingent consideration, being 5 per cent of the EBITDA exceeding INR50 million earned by ABC Ltd in the next two years of its operation, as a lump sum in the second year. The fair value of the liability for contingent consideration was INR30 million on initial recognition and INR36 million as on the reporting date.

• How should the contingent consideration liability be categorised within the fair value hierarchy disclosure; and

• What are the other fair value related disclosures applicable to this instrument?

A. As per Ind AS 109, the company should recognise and measure the financial liability for contingent consideration at fair value through profit or loss (FVTPL). The inputs required for computing fair value would include variables such as forecast revenues, EBITDA and an appropriate discount rate. Some of these inputs are unobservable in nature, being specific to the company. Therefore, the fair value of the financial liability at reporting date (INR36 million) should be categorised as a Level 3 measurement in the fair value hierarchy disclosure.

Ind AS 113 prescribes additional disclosures for financial instruments measured at FVTPL and categorised under Level 3 of the fair value hierarchy. Company X should therefore disclose:

a. A description of the valuation process and technique used to measure the fair value of the liability, including how it decides its valuation policies and procedures and analyses changes in the fair value measurement from period to period

b. Quantitative information about significant unobservable inputs used for the fair value measurement, where such quantitative information are significant to the fair value measurement and are reasonably available to the company

c. The amount of unrealised gains or losses earned/incurred during the financial period on the contingent consideration liability existing as on the reporting date and the line item in the statement of profit and loss in which the entity records, the unrealised gains or losses on such liability.

d. A reconciliation from the opening balances to the closing balances, disclosing separately changes during the period attributable to:

– Total gains or losses for the period recognised in the profit or loss or other comprehensive income (OCI) and the line item in the profit or loss or the OCI in which it is recognised.

– Purchases, sales, issues and settlements (each of these changes disclosed separately)

– Amount of transfers into or out of Level 3 of the fair value hierarchy, to be disclosed separately along with reasons for those transfers.

e. A sensitivity analysis of the fair value measurements, by making changes in unobservable inputs, where such a change would result in a significantly higher or lower fair value measurement.

f. Interrelationships between significant unobservable inputs used in the fair value measurement and how they may (together) magnify or mitigate changes in fair value of the liability on account of a change in those inputs



Sr. No.

Particulars Carrying amount (INR in millions)

1 3 month futures contract, actively traded on the futures exchange, for sale of 100,000 shares of company ABC at INR100 per share, to be settled net in cash.

1.5

2 Forward contracts to sell USD25 million at INR68 per USD to hedge forecast sales expected to occur after 6 months.

2.7

3 Written put option to non-controlling shareholders (NCI) to sell 15% of the remaining shareholding in its subsidiary to the company at INR87 million, exercisable within the next year.

77.8

Q 4. On 1 April 2016, company M extended an employee loan of INR4 million, repayable after three years at an interest rate of 2 per cent per annum. The bank interest rate for personal loans offered to salaried individuals for the same amount and with a similar maturity was 12 per cent per annum at the time of providing the loan, and is 11.75 per cent per annum as on the reporting date. The carrying amount of the loan at the balance sheet date is INR3 million. What are the fair value disclosure requirements for this loan and in which level of the fair value hierarchy should it be categorised?

A. The company classifies and subsequently measures the loan extended to an employee at amortised cost. However, it needs to disclose the fair value of this loan at year end and categorise this in the appropriate level of the fair value hierarchy. For computing the fair value of the loans, the entity should discount the future cash flows of the loan at the market rate of return applicable to similar instruments as on the balance sheet date, which is 11.75 per cent per annum. Accordingly the fair value of the loan as on the reporting date is INR3.3 million.

Ind AS 113 requires company M to disclose the valuation techniques and inputs used to compute the fair value of the loan, the entity may consider providing the below note as part of its fair value disclosures:

‘The valuation model adopted for computing the fair value of the employee loans is the discounted cash flow model, where the present value of inflows is discounted using a market interest rate’.

The interest rate used to discount the future cash flows of the loan would be the market rate of return on similar financial instruments. Since this is generally an observable input, the loan may be categorised within Level 2 of the fair value hierarchy disclosure.

A. The fair value disclosure requirements for the derivatives listed above are as follows:

• Futures contract: The three - month futures contract is recognised and measured in the financial statements at FVTPL. Since this derivative is actively traded on a futures exchange, its price is quoted in an active market. Accordingly, the fair value of the contract is measured at its quoted price, being the most reliable evidence of fair value. Therefore, the futures contract will be categorised as Level 1 in the fair value hierarchy disclosure.

• Forward contracts: The forward contracts are recognised and measured in the financial statements at FVTPL. Since these contracts are not actively traded, a quoted market price is not available for them. The fair value of these contracts is generally determined on the basis of the change in forward rates offered by counterparties at the reporting date, discounted using the market interest rate applicable to the entity. The forward rates and discount rates are not ‘quoted prices’ but would be considered as observable or market corroborated inputs. Therefore, the forward contracts would generally be categorised within Level 2 of the fair value hierarchy disclosure.

The company should also disclose the valuation techniques and inputs used to compute the fair value of the forward contracts.

• Written put option to NCI: The written put options to NCI are recognised and measured as a liability at fair value, being the present value of the exercise price, in accordance with Ind AS 32, Financial Instruments: Presentation. The company has elected an accounting policy to recognise changes in the put liability through FVTPL. The fair value of such instruments would generally be computed using a valuation model with some of the inputs being specific to the company, for example, forecast revenue growth rate, risk-adjusted discount rate, volatility in share price, etc. Considering that some of the inputs used to compute the fair value of the put option liability may be unobservable, it would generally be categorised as Level 3 in the fair value hierarchy disclosure . Similar considerations would apply when computing the fair value of a long term put option liability, even if the company was listed. Some of the inputs used to compute the fair value of a long term put option liability, such as volatility in share price, may be unobservable, indicating a Level 3 categorisation.

Q 5. Company D, an unlisted entity, has entered into certain derivative contracts of which the following are outstanding on the balance sheet date:

What are the fair value disclosure requirements for these instruments and their categorisation in the fair value hierarchy disclosure?



Credit risk

Q 6. R Ltd. has measured the expected credit loss (ECL) on its retail trade receivables using the simplified approach permitted in paragraph 5.5.15 of Ind AS 109. Accordingly, the company recognises lifetime expected credit losses on its trade receivables based on a provision matrix. The ageing of the receivables and the corresponding ECL as on 31 March 2017 are given below:

Ageing Debtors (INR in millions) Expected loss

Not due 86 0.90%

1-90 days 42 1.50%

91-180 days 18.5 5.00%

181-270 days 3 13.50%

271-360 days 2 36.00%

More than 360 days 0.5 100.00%

The expected loss balance in respect of trade receivables as on 31 March 2016 was INR2.5 million. R Ltd. has also written off debtors of INR0.8 million during the year. What details should be provided by the company in its credit risk disclosures?

A. Ind AS 107 requires an entity to disclose the gross carrying amount of the receivables and its exposure to credit risk. Since the ECL on the receivables has been computed using a provision matrix R Ltd. should, in accordance with para B5.5.35 of Ind AS 109, provide the methodology for computing the loss rates and disclose, how these loss rates reflect the management’s view of economic conditions over the expected lives of the receivables. The company should also provide a reconciliation from the opening balance to the closing balance of the ECL. The entity may consider adding the following content in its credit risk disclosures:

Based on industry practices and the business environment in which the entity operates, the management considers that the trade receivables are in default (credit impaired) if the payments are more than 360 days past due.

The company uses an allowance matrix to measure the expected credit losses on its retail trade receivables. Loss rates are calculated based on actual credit loss experience over the last ten quarters. These rates have been adjusted to reflect the management’s view of the economic conditions over the expected lives of the receivables.

The movement in the expected credit loss allowance during the year was as follows:

Particulars Amount in INR (millions)

Balance as at 1 April 2016 2.5

Measurement of loss allowance 2.2

Less: Amounts written off (0.8)

Balance as at 31 March 2017 3.9

During the year, trade receivables of INR0.8 million were written off.

31 December 2016

Gross carrying amount (INR in millions)

Expected credit loss rate

Expected credit losses (INR in millions)

Whether receivable is credit impaired

Carrying amount of trade receivables

Not due 86.0 0.90% 0.8 No 85.2

1-90 days 42.0 1.50% 0.6 No 41.4

91-180 days 18.5 5.00% 0.9 No 17.6

181-270 days 3.0 13.50% 0.4 No 2.6

271-360 days 2.0 36.00% 0.7 No 1.3

More than 360 days 0.5 100.00% 0.5 Yes -

Total 152 3.9 148.1

Expected credit loss assessment for retail trade receivables





Liquidity risk

Q 7. Company L has the following contractual obligations in respect of its financial liabilities as on 31 March 2017:

Sr. no.

Particulars Amounts

1 Monthly finance lease obligation (including interest); this will expire on 31 March 2020. INR1 million per month

2 Quarterly principal repayment of INR loan, payable until 30 September 2019. (Outstanding loan amount as on 31 March 2017 is INR5 million. The next instalment is due on 30 June 2017. Interest on such loan is at the rate of 12% per annum on the outstanding amount, payable quarterly)

INR0.5 million per quarter

3 Annual repayment of principal on a foreign currency loan, payable until 31 December 2019.

(Outstanding loan amount as on 31 March 2017 is USD1.5 million, next instalment is due on 31 December 2017. Interest on such loan is at 4.5% per annum, payable annually. USD-INR exchange rate as on 31 March 2017 is INR68.15)

USD0.5 million per annum

4 Trade payables (of which INR0.4 million is payable within 180 days and INR0.4 million after 180 days but within 360 days)

INR0.8 million

5 Company L also has undrawn credit facilities of INR100 million from its bank at 12.5% p.a. It intends to draw these funds in FY 2017-18. This loan is repayable in 10 equal instalments starting from 1 April 2019.

INR100 million

What amounts and time brackets should the entity disclose in respect of its exposure to liquidity risk?

A. Ind AS 107 requires an entity to describe how it manages its liquidity risk, which may include information on its processes for managing liquidity, including its funding sources and its liquid investments. Ind AS 107 also requires a quantitative maturity analysis to be provided disclosing the remaining contractual maturities of non-derivative as well as derivative financial liabilities. The entity should disclose such quantitative data based on the information provided internally to key management personnel. In order to determine the time brackets that should be used to group its cash flow obligations, the company should exercise judgement based on the frequency and materiality of the cash flows. Based on the cash flow obligations of company L, half-yearly time brackets may be considered appropriate for its maturity analysis, as illustrated below:

ParticularsAmount in INR (millions)

0-6 months 6-12 months 12-18 months 18-24 monthsMore than 24

months

Monthly finance lease obligation 6 6 6 6 12

Repayment of INR Loan 1.29 1.23 1.17 1.11 1.05

Repayment of foreign currency loan*

- 38.7 - 37.1 35.6

Trade payables 0.4 0.4 - - -


* The INR amounts for cash flows relating to the foreign currency loan are determined on the basis of the spot rate as on 31 March 2017.

The cash outflows should be disclosed at their undiscounted amounts and include contractual interest payments. Hence, the company may consider adding a note to clarify that the amounts in the maturity analysis table would not match the carrying amounts of the corresponding financial instruments in the financial statements.

In the current illustration, the company has elected to not disclose the undrawn credit facilities in its quantitative maturity analysis. It may disclose the details of such facilities in its qualitative disclosures if it considers that these are relevant to an understanding of the company’s liquidity position.




Q 8. Company D has entered into the following derivative contracts on 1 January 2017 to hedge its currency and interest rate risks:

Particulars Method of settlement Carrying amount

A pay fixed/receive floating interest rate swap to hedge cash flow variability on its floating rate USD loan. The notional amount of the swap is USD5 million. Company D is required to make semi-annual payments in USD on the swap at a fixed rate of 2% per annum and receive USD amounts at a floating rate of 6-month LIBOR per annum. The interest on the loan and on the swap is payable on a semi-annual basis on 31 March and 30 September each year, till the entire loan is repaid-i.e. until 30 September 2020.

The difference between the pay/receive streams of the swap would be settled net with the bank at each interest payment date.

Fair value liability of INR0.72 million.

A fixed-to-fixed principal cum interest cross currency swap, to hedge the cash flow variability arising from repayment of a 4.5% per annum foreign currency loan of USD1 million. The company is required to pay interest quarterly in INR at 6% per annum and receive USD amounts at 4.5% per annum. The swap also includes an exchange of principal of USD0.125 million every quarter for INR8.36 million (at a fixed rate of INR66.9 per USD) until maturity, being 31 March 2019. The next settlement date for the swap is 30 June 2017.

Every quarter, the entity pays the bank INR8.36 million and interest at 6% per annum on the outstanding INR amount and receives USD125,000 and interest at 4.5% per annum on the outstanding USD amount. Hence, the swap is gross settled.

Fair value asset of INR0.3 million.

Forward exchange contracts to sell EUR at a EUR/INR rate of 73.5, maturing on 1 August 2017, to hedge outstanding debtors of EUR800,000.

Difference between spot and forward rate to be settled net in cash with the bank.

Fair value liability of INR0.8 million.

As on 31 March 2017, the USD/INR spot rate is 68.31 and the EUR/INR forward rate is 74.62 respectively, and 6-month LIBOR as on 31 March 2017 is 1.33 per cent. What should the entity disclose in its maturity analysis for exposure to liquidity risk?

A. Ind AS 107 requires an entity to disclose the gross/net cash flows of a transaction based on the manner in which the contract is settled. Accordingly, the entity should compute the amounts to be disclosed for these derivative instruments in the following manner:

Contract Basis of disclosure

Pay fixed/receive floating interest rate swap

Since the swap is net-settled, the company should disclose the net undiscounted cash flows payable on the swap. The net settlement amount payable to/receivable from the bank up to 30 September 2020 should be determined on the basis of the 6-month LIBOR forward curve. This amount, converted into INR at the spot rate as on 31 March 2017 should be disclosed in the relevant time brackets as the expected cash outflow/(inflow) for the entity on the derivative contract.

Principal cum interest cross currency swap

The swap has a positive fair value, i.e. is a financial asset at 31 March 2017. Therefore, the company is not required to include the cash flows relating to this swap in its maturity analysis for exposure to liquidity risk. However, the company may elect a policy of disclosing cash flows relating to all derivatives since the fair value of a derivative may change from one reporting date to the next. Since the swap is gross settled, the company would have to disclose the gross cash outflows relating to the swap in the relevant time brackets. It may be preferable to also disclose the gross cash inflows in order to provide more meaningful information on liquidity risk.

EUR/INR forward exchange contracts

Ind AS 107 requires entities to disclose their undiscounted cash outflows based on conditions existing on the reporting date. Since the fair value of the forward contract on the reporting date represents the net settlement amount of the contract, company D should disclose the fair value of the forward contract in its maturity analysis.



Q 9. Company X holds 80 per cent of ordinary shares in company XY (an unlisted company). Company X has written a put option in favour of the non-controlling interest (NCI) shareholder to sell the balance 20 per cent shareholding in company XY to company X for INR100 million. The option can be exercised at any time until company X controls company XY. The fair value of the put option as on 31 March 2017 is INR20million.

• Should company X include the written put option in its liquidity risk disclosure and if yes, at what amount?

• If the exercise price of the put option is the fair value of the shares on the exercise date (instead of a fixed amount), what would be the amount disclosed in the liquidity risk analysis?

A. Exercise price of the put option is fixed: Ind AS 107 requires an entity to disclose the remaining contractual maturities of its derivative financial liabilities, where such contractual maturities are essential for an understanding of the timing of the cash flows. Company X could be required to pay the exercise price on the option exercise date, i.e. on any date after the reporting date at the option of the NCI holder as long as company X controls company XY. Therefore, company X should disclose the entire amount that it could be required to pay to settle its obligation (i.e. INR100 million) in the earliest period in which the option could be exercised. Such disclosure is essential for the users of the financial statements to understand the timing of the cash flows and the company’s exposure to liquidity risk.

Company X may consider adding a note that the exercise of put option would result in recognition of additional investment.

Option exercisable at fair value of shares: It is essential for the entity to disclose the probable cash outflow relating to the put option written by it on NCI. However, where the amount of outflow is not fixed, the entity would be required to estimate the amount payable based on the fair value of the underlying shares on each reporting date. Considering the complexity involved in estimating the fair value of equity shares of an unlisted company, the company may consider the involvement of a valuation expert.

Q 10. Company D has taken a term loan of INR100 million from its bank on 1 April 2016 at an interest rate of 11 per cent per annum, payable monthly. The principal amount of the loan is repayable on 30 June 2019. Company A, the parent entity of company D has provided a financial guarantee for the loan to the bank. In accordance with the terms of the guarantee, company A would be liable to pay the bank if company D fails to make a payment on the loan within 30 days after it is due. Company D has been making timely interest payments to the bank since the initiation of the loan. What would company A be required to disclose in its liquidity risk analysis in respect of the guarantee provided?

A. Ind AS 107 requires the entity to disclose the maximum amount of guarantee that could be called for, in the earliest period in which it could be called, since it is an obligation of the entity in situations which are outside its control. Accordingly, company A should disclose its possible obligation for payment of monthly interest amounts (in the relevant time bracket as if these amounts were 30 days past due) as well as the principal amount of the loan (i.e. INR100 million) as payable 30 days after its due date of 30 June 2019 . The company may consider providing additional information to distinguish the financial guarantee from other financial liabilities in its liquidity risk disclosure to highlight the contingent nature of the amounts payable under the guarantee.


Therefore, the approximate amounts to be included in the disclosure on maturity analysis for the derivatives in the illustration above are computed as follows . The company should include these amounts in the relevant time brackets applicable to its liquidity risk disclosure.


0-3 months 3-6 months 6-9 months 9-12 monthsMore than 12

months

Pay fixed/receive floating interest rate swap

- 1.14 - 0.37 (0.80)

Principal cum interest cross currency swap:

Inflow 9.12 9.02 8.93 8.83 34.39

Outflow 9.34 9.24 9.11 8.99 34.70

EUR/INR forward exchange contracts

- 0.90 - - -


Foreign currency risk

Q 11. Company G with an INR functional currency holds trade receivables of USD 500,000 and EUR 200,000, and trade payable of USD400,000 at the reporting date. Its subsidiaries have the following outstanding exposures:

• Company A, with a functional currency of USD, holds trade receivables of INR3 million and trade payables of USD600,000;

• Company B with a functional currency of SGD, holds trade receivables of INR1 million and AUD10,000.

Which currencies should be included in the quantitative disclosure for exposure to foreign currency risk in the consolidated financial statements of company G?

A. Ind AS 107 requires entities holding financial instruments denominated in a currency which is different from the functional currency of the entity, to disclose these as exposures to foreign currency risk. While preparing consolidated financial statements, group companies may have functional currencies which are different from that of the parent entity. Hence, such group companies may have foreign currency exposure in the form of financial instruments denominated in the functional currency of the parent entity. These should be included in the disclosure for exposure to currency risk in the consolidated financial statements of the group.

Accordingly, the disclosure relating to foreign currency risk in the consolidated financial statement should include the following amounts:

Amount in31 March 2017

INR USD EUR AUD

Trade receivables 4,000,000 500,000 200,000 10,000

Trade payables - (400,000) - -

Net exposure 4,000,000 100,000 200,000 10,000

Payables amounting to USD600,000 of company A will be excluded from this disclosure as these payables are denominated in the functional currency of company A (i.e. USD) and do not represent an exposure to foreign currency risk for company A.

Q 12. Company H, which has INR as its functional currency, holds 100 per cent shares in company S, which has USD as its functional currency. The entities have the following inter-company balances as on 31 March 2017:

Company S

Particulars Currency Amount

Receivable from H USD 10 million

Payable to H USD 2 million

Company H

Particulars Currency Amount

Payable to S USD 10 million

Receivable from S USD 2 million

How should the group disclose its exposure to foreign currency risk as on the reporting date in its consolidated financial statements?

A. Ind AS 107 requires entities holding financial instruments that are denominated in a currency which is different from the functional currency of the entity to disclose these as exposures to foreign currency risk. While the intercompany balances would be eliminated on consolidation, the parent entity, company H, remains exposed to foreign currency risk since the USD balances are denominated in a currency other than its functional currency (being INR). Therefore, the foreign currency receivable/payable amounts should be included in the disclosure on foreign currency risk in the consolidated financial statements.




Q 13. Company M, with INR as its functional currency, imports raw materials and exports finished products to several countries and has unhedged foreign currency exposures of the following amounts:

Particulars USD EUR GBP CHF AUD SGD JPY

Receivables 10,000,000 5,000,000 4,000,000 10,000 4,000 3,000 2,000

Payables 3,000,000 100,000 3,750,000 - - 600 -

Net exposure 7,000,000 4,900,000 250,000 10,000 4,000 2,400 2,000

What foreign currency risk exposures should the company disclose in its financial statements under Ind AS?

A. Ind AS 107 requires an entity to include currencies to which it has significant exposure as part of its disclosures on foreign currency risk and its sensitivity analysis. In the example above, the entity’s net exposure to USD and EUR constitutes approximately 97 per cent of its net foreign currency exposure, indicating that the company’s disclosures on foreign currency risk should comprise these two currencies. Although an entity may generally determine the currencies to be disclosed on a net basis, this approach would not be appropriate if it does not suitably represent the entity’s exposure to currency risk. For example, if an entity has short term payables and long term receivables denominated in USD it may be more appropriate to determine the currencies to be disclosed on the basis of the gross exposure.

In the illustration above, since the gross receivables and payables in GBP approximate 24 per cent of the total receivables and 59 per cent of the total payables of the entity respectively, it may be relevant to also include the GBP exposure in the company’s disclosures on foreign currency risk. Accordingly, the company may include the USD, EUR and GBP amounts in its disclosures on foreign currency risk. The exposures to other foreign currencies may be excluded as they are not likely to be individually significant from a foreign currency risk disclosure perspective.

Q 14. On 31 March 2017, company S forecasts exports of USD 6 million in September 2017. In order to hedge a portion of its forecast exports, the company has entered into foreign currency forward contracts with its bank to sell USD5 million at INR68.9, maturing on 30 September 2017. The forward contracts would be net settled in cash on maturity. While preparing its foreign currency risk disclosure, should company S disclose the forecast foreign currency transactions along with the derivative instruments?

A. The forward exchange contracts are financial instruments that represent exposure to foreign currency risk and are required to be disclosed by company S as part of its disclosure on foreign currency risk.

While the forward exchange contracts have been transacted to hedge the currency risk on the forecast sales, these underlying transactions do not meet the definition of a financial instrument under Ind AS 32. Therefore, company S is not required to mandatorily include its forecast USD exports in its disclosure on foreign currency exposure. However, if the company considers that such a disclosure would be relevant for a complete understanding of its exposure to currency risk, it may be preferable to provide these details voluntarily and ensure that they are clearly and accurately described.



Q 15. Company S holds the following GBP receivables and payables as on 31 March 2016 and 31 March 2017, respectively:


31 March 2017 31 March 2016

Receivables 200,000 75,000

Payables 150,000 100,000

Spot rate 82.00 95.08

When performing a sensitivity analysis to changes in currency rates as on 31 March 2016, the company had considered 3 per cent as the reasonably possible change in GBP/INR foreign exchange rates. This was based on the observed deviation in the GBP/INR exchange rates in that financial year. In the financial year ended 31 March 2017, the deviation in GBP/INR rate is approximately 5.6 per cent. What are the considerations for company S when analysing the sensitivity to foreign currency rates as on 31 March 2017?

A. Ind AS 107 requires an entity to provide a sensitivity analysis for exposure to each market risk, including the impact of changes in the risk variable on profit and loss or equity. Generally, the sensitivity analysis for foreign currency risk is based on the reasonably possible change in the foreign exchange rates, expressed as a percentage that may be derived from the historical deviation in the spot rate over the reporting period. The estimated possible change in the variable may therefore differ from one reporting period to another. The sensitivity analysis of the previous year would not be restated for any changes in the percentage of deviation in the variable. In the example above, the sensitivity analysis could be presented as follows:

ParticularsProfit or loss (Amount in INR (millions))

Strengthening Weakening

31 March 2017

GBP (5.6% movement) 229,600 (229,600)

31 March 2016

GBP (3% movement) (71,310) 71,310

Q 16. Company F has entered into the following forward contracts to hedge its underlying forecast foreign currency transactions:

Particulars UnderlyingNotional amount

Maturity date Forward rateSpot rate on date of transaction

Spot rate on balance sheet date

Forward contract 1

Forecast USD purchases USD1 million 15 June 2017 INR69.81 INR67.66 INR68.15

Forward contract 2

Forecast USD sales USD10 million 31 December

2017 INR69.95 INR67.15 INR68.15

How should the entity disclose these forward exchange contracts in its sensitivity analysis for exposure to foreign currency risk?

A. For computing the sensitivity analysis for foreign currency risk arising from a forward exchange contract, the company is required to apply a percentage that represents a reasonably possible change in the foreign exchange rates to the notional amount of the forward contract. This ‘reasonably possible change’ in foreign currency rates is generally determined on the basis of the standard deviation in spot exchange rates pertaining to that foreign currency for the past year.

Generally, while analysing the sensitivity to changes in foreign exchange rates for forward contracts, an entity may assume that the forward premium remains unchanged and only the spot component is subject to sensitivity. Accordingly, the impact of sensitivity to foreign exchange rates is determined by applying the percentage of change in exchange rates (determined as above) to the spot exchange rate as on the reporting date, multiplied by the notional amount of the forward exchange contract.

However, in cases where the quantum of exposure to forward exchange contracts is significant, the entity may consider using a valuation expert to determine the sensitivity to foreign currency risk based on forward rates prevailing on the reporting date.

In the example above, company F should consider the significance of the foreign currency derivative transactions to determine the approach to be adopted for the sensitivity analysis.




Q 17. On the date of transition to Ind AS, company L had an outstanding loan of USD 7 million, at an interest of 5.5 per cent per annum, repayable on 31 December 2020. The company had borrowed these funds to make payments to suppliers for import of machinery. In its financial statements prepared in accordance with the previously applicable generally accepted accounting principles in India (previous IGAAP), the company had elected to capitalise the foreign exchange differences arising on the loan in the cost of the machinery, as permitted by paragraph 46 of Accounting Standard 11, The effects of changes in foreign exchange rates. On transition to Ind AS, the entity exercised the option available under para D13AA of Ind AS 101, First-time adoption of Indian Accounting Standards, to continue capitalising the foreign exchange differences arising on this long-term foreign currency loan in the cost of the machinery. Should the company include the foreign currency loan in its disclosure on sensitivity analysis under Ind AS 107 for exposure to foreign currency risk?

A. Ind AS 107 requires entities to disclose their exposure to foreign exchange risk on financial instruments and provide a sensitivity analysis indicating the effect of a change in foreign exchange rates on profit and loss or equity.

In the example above, although the foreign exchange differences on the long-term foreign currency loan are capitalised in the cost of the related asset, these amounts would ultimately affect the statement of profit and loss when the asset is depreciated over its useful life. Hence, the entity should include the foreign currency loan in its sensitivity analysis for exposure to foreign currency risk.

The entity may consider adding a note as follows:

The sensitivity analysis to foreign currency risk includes an exposure to foreign exchange fluctuations on long term foreign currency loans of USD7 million that have been capitalised into the cost of the related asset and are expected to impact profit or loss over a period of x years in the form of an adjustment to the depreciation charge.

Market price riskQ 18. Company I holds long-term investments in the equity shares of certain entities that are listed on the Bombay Stock Exchange (BSE) and has elected to measure them at FVOCI. The carrying amount of the investments as on 31 March 2017 and 31 March 2016 is INR5 million and INR4.8 million respectively. What should the entity disclose in its sensitivity analysis for exposure to share price risk relating to these investments in equity shares?

A. Ind AS 107 requires an entity to disclose its exposure to market risk and provide a sensitivity analysis for the impact of changes in the risk variable on the profit and loss or equity of the entity. Share price risk is a part of the company’s exposure to market risk and should be considered in the sensitivity analysis disclosure.

The company should determine the correlation, if any, between the market price of the equity instruments and the equity index. The sensitivity analysis may then be disclosed as the impact on profit and loss or equity arising from exposure to the equity instruments as a result of a percentage variation in the index. There may be a scenario where the quantum of investments

in equity instruments is large and the level of exposure of the entity to price risk is high, or it is impracticable to establish a correlation between the market price of the equity instruments and the index, for example for mutual fund investments. The entity may, in that case compute the sensitivity based on a percentage fluctuation in the market price of the respective equity instruments.

The entity may consider providing a disclosure as illustrated below for its exposure to equity price risk:

The entity is exposed to equity price risk, which arises from investments made in equity securities listed on the Bombay Stock Exchange. Material investments within the portfolio are managed on an individual basis and all buy and sell decisions are approved by the Risk Management Committee.

Sensitivity analysis

The company’s investments in shares of publicly listed companies amounting to INR5 million (2016: INR4.8 million) are generally exposed to a risk of fluctuations in fair value. A 10 per cent increase in the BSE market index at the reporting date would increase equity by INR0.45 million (2016: INR0.43 million). An equal change in the opposite direction would decrease equity by INR0.45 million (2016: INR0.43 million).

Interest rate riskQ 19. Company B has invested INR8 million in corporate bonds of a listed company, carrying a fixed interest rate of 8.5 per cent per annum. These investments are classified and measured at amortised cost. The market interest rate as on 31 March 2017 for corporate bonds with similar remaining term to maturity and credit characteristics is 9 per cent. Does the entity need to present a sensitivity analysis for the impact on profit and loss or equity due to a change in the market interest rates?

A. Ind AS 107 requires an entity to disclose exposure to market risks in its financial statements and perform a sensitivity analysis that presents the impact of a reasonably possible change in the variable on the profit and loss or equity of the company. The corporate bonds held by the entity carry a fixed rate of interest rate and are measured at amortised cost in the company’s Ind AS financial statements. A change in the market rate for instruments with similar terms would impact the fair value of these bonds. However, there would be no impact on the carrying amount of the instrument, or the profit and loss or equity of the company since the bonds are not measured at fair value. Company B would therefore not be required to present a sensitivity analysis for its exposure to interest rate risk on these investments . If the bonds were variable rate instruments (i.e. carried a floating rate of interest), a change interest rates would have an impact on the profit or loss of the company due to a change in interest income. Therefore, the company would be required to present a sensitivity analysis on such variable rate instruments.

If the company has hedged the interest rate risk on the fixed rate corporate bonds using a fixed-to-floating interest rate swap and designated this as a fair value hedge under Ind AS 109, the bonds would be measured at FVTPL for changes in the hedged risk (i.e. changes in market interest rates). In this scenario, the change in market interest rates would have an impact on profit and loss and the corporate bonds may be included in the sensitivity analysis for exposure to interest rate risk.



Q 20. Company L has the following financial liabilities as on 31 March 2017:

Sr. no. Particulars

Carrying amount in INR (millions)

1 Working capital loan at floating rate, interest is reset on a monthly basis. Interest as on 31 March 2017 is 11.5% per annum 12

2 Foreign currency loan of USD15 million, at 6-month LIBOR + 2.3% per annum, repayable on 30 September 2019 (As on 31 March 2017, the 6-month LIBOR was 1.5%) 980

3

USD15 million, pay fixed/receive floating USD interest rate swap to hedge the cash flow variability arising due to interest rate risk on the foreign currency loan. As per the terms of the swap, the entity is required to pay a fixed interest rate at 2.3% per annum and receive floating interest at 6-month LIBOR.

12.4

How should the entity compute the sensitivity analysis for the above financial instruments?

A. Ind AS 107 requires an entity to compute the sensitivity analysis by estimating a reasonably possible change in the relevant risk variable; this may be computed on the basis of the economic environment in which the entity operates and the time frame over which it is making the assessment.

For the purpose of computing interest rate sensitivity on the borrowings above, management has estimated a reasonably possible change in interest rates as 1 per cent based on current as well as expected economic conditions. The company may consider adding the following note:

A reasonably possible change of 100 basis points in interest rates across all yield curves at the reporting date would have increased (decreased) equity and profit or loss by the amounts shown below. This analysis is based on risk exposures outstanding at the reporting date and assumes that all other variables, in particular foreign currency exchange rates, remain constant. The period end balances are not necessarily representative of the average amounts outstanding during the period.

Computation of the interest rate sensitivity (Amounts in INR)

ParticularsProfit or loss Equity

100 bp increase 100 bp decrease 100 bp increase 100 bp decrease

31 March 2017

Working capital loan (120,000) 120,000 - -

Foreign currency loan (9,800,000) 9,800,000 - -

For the purpose of computing sensitivity on the interest rate swap, the entity may assume a 1 per cent change in the floating rate of interest (i.e. the LIBOR). Accordingly, the change in the net cash flows on the swap should be disclosed as an additional/lower charge to the statement of profit and loss.

Such a change in the interest rate would also affect the fair value of the swap. Since the swap is a designated hedging instrument, the change in fair value of the instrument would be charged/credited to equity. The entity may accordingly, disclose the sensitivity in its interest rate risk disclosures as follows.

Particulars(Amount in INR)

Profit or loss Equity

100 bp increase 100 bp decrease 100 bp increase 100 bp decrease

31 March 2017

Interest rate swap (10,072,500) 10,072,500 (25,990,840) 25,990,840





Master netting arrangementsQ 21. On 1 April 2016, company V, a manufacturer of consumer goods, entered into an agreement to provide volume rebates to its large wholesale customers. As per the agreement, the rebates payable to the customers would be computed at the end of the financial year, considering the volume of sales made to those customers during the financial year. These rebates would be reduced from amounts receivable from the customers at the end of the financial year.

The amounts receivable from these customers at 31 March 2017 were as follows:

Customer Amount receivable (in INR) Rebate payable (in INR)

Company A 12,000,000 650,000

Company X 15,000,000 700,000

Company P 20,000,000 1,200,000

Total 47,000,000 2,550,000

What are the disclosures to be made by the entity in its financial statements for these transactions?

A. Ind AS 32 requires the presentation of financial assets and financial liabilities on a net basis in the financial statements, when doing so reflects the entity’s right to receive or pay a single net amount and its intention to do so. As per the volume rebate agreements entered into by company V with its customers, the company has a legal right to offset the rebate payable to the customers against amounts receivable from them. This contract also confirms the company’s intention to settle the rebate payable to the customers on a net basis with the related trade receivable. Accordingly, company V should present in its financial statements the net amounts receivable from companies A, X and P as trade receivables of INR11,350,000, 14,300,000 and 18,800,000.

Ind AS 107 also requires entities to disclose the following information pertaining to all recognised financial instruments that are set off in accordance with Ind AS 32:

a. The gross amounts of the recognised financial asset and the recognised financial liabilities

b. The amounts that are set-off in accordance with the criteria prescribed in Ind AS 32

c. The net amounts presented in the balance sheet.

Company V may include the following amounts in its disclosures for the transactions described above:

Effect of offsetting on the balance sheet

31 March 2017 Gross amountsGross amounts set off in the balance sheet

Net amounts presented in the balance sheet

Financial assets

Trade receivables 47,000,000 (2,550,000) 44,450,000


Trade payables 36,000,000 (2,550,000) 33,450,000



(Amounts in INR)


Q 22. Company A entered into an International Swaps and Derivatives Association (ISDA) Master Agreement with its bank relating to the over-the-counter (OTC) derivative contracts purchased from the bank. As per the ISDA agreement, if on any date, amounts are payable by company A and the bank, in the same currency (regardless of whether they pertain to the same transaction), the amounts will be considered to be discharged or will be net settled, where the amounts are different. As on 31 March 2017, company A had the following derivative instruments:

Derivative contracts Notional amount (INR) Carrying amount (INR)

Forward contract to sell USD5,000,000 at INR69 on 30 June 2017 34,500,000 2,500,000

A pay fixed/receive floating cross currency interest rate swap. The notional amount of the swap is USD10 million. Company A is required to make semi-annual payments (on 31 March and 30 September each year until 31 March 2020) in INR on the swap at a fixed rate of 2% per annum at INR68 per USD and receive USD amounts at a floating rate of 6-month LIBOR per annum on the USD notional amount.

680,000,000 (14,000,000)

What are the disclosures to be presented by the entity for the master netting arrangement entered into with the bank in relation to these derivatives?

A. Ind AS 32 prescribes that where an entity enters into a ‘master netting arrangement’ which provides for a single net settlement of all financial instruments covered by the agreement in the event of default, or termination of, any one contract, the financial assets and financial liabilities subject to the master netting agreement should be offset and presented net in the financial statements. However, where the Ind AS 32 criteria for offset of the financial assets and the financial liabilities subject to the master netting arrangement is not satisfied, the entity should, in accordance with Ind AS 107 disclose:

a. The net amounts presented in the balance sheet

b. The amounts related to recognised financial instruments that do not meet some or all of the offsetting criteria.

The entity may consider including the amounts below in its disclosure on master netting arrangements:

Amounts not offset (Amount in INR)

31 March 2017Gross and net amounts of financial instruments in the balance sheet

Related financial instruments that arenot offset

Net amount (*)

Financial assets

Interest rate swaps used for hedging (14,000,000) 2,500,000 (11,500,000)


Forward exchange contracts used for hedging 2,500,000 (14,000,000) -

* The net amount is disclosed as per the requirements of Ind AS 107 and represents the difference between the net amounts presented in the balance sheet (that are subject to an enforceable master netting arrangement) and the amounts related to these recognised financial instruments that do not meet some or all of the offsetting criteria in Ind AS 32.





Notes

Notes

Our PublicationsKPMG in India’s IFRS instituteVisit KPMG in India’s IFRS institute - a web-based platform, which seeks to act as a wide-ranging site for information and updates on IFRS implementation in India.

The website provides information and resources to help board and audit committee members, executives, management, stakeholders and government representatives gain insight and access to thought leadership publications that are based on the evolving global financial reporting framework.

MCA issued relaxation for an IFSC company located in an SEZ

17 January 2017

On 2 September 2015, Securities and Exchange Board of India (SEBI) notified the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Listing Regulations). Clause 34(2)(f) of the

Listing Regulations requires mandatory submission of Business Responsibility Report (BRR) for top 500 listed entities based on market capitalisation (calculated as on 31 March of every year). The BRR should describe the initiatives taken by the companies from an environmental, social and governance perspective, in the format as specified by SEBI from time to time.

New development

The SEBI issued a circular dated 6 February 2017, advising top 500 listed companies which are required to prepare BRR to adopt IR on a voluntary basis from the Financial Year (FY) 2017-18.

This issue of First Notes provide an overview of the SEBI circular and requiremnets of Integrated reporting.

KPMG in India is pleased to present Voices on Reporting – a monthly series of knowledge sharing calls to discuss current and emerging issues relating to financial reporting.

In our recent call, on 8 February 2017, we provided an overview and implications of the proposals given in the Finance Bill, 2017 on the following topics:

• Computation of book profit for Ind AS compliant companies for the purpose of levy of MAT

• Income Computation and Disclosure Standards

• Change in base of cost inflation index from 1 April 1981 to 1 April 2001

• MAT credit allowed to be carried forward to 15 Assessment Years.

Missed an issue of Accounting and Auditing Update or First Notes?

IFRS NotesICAI issues exposure draft of Schedule III for NBFCs as per Ind AS

13 February 2017

On 6 February 2017, the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI) issued the Exposure Draft (ED) of the Ind AS compliant Schedule III to the Companies Act, 2013 for Non-Banking Financial

Companies (NBFCs).

The ED sought comments and the last date to provide comments is 6 March 2017.

This issue of IFRS Notes provide an overview of the Ind AS compliant Schedule III for NBFCs.

Introducing

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Financial Instruments: Application issues under Ind AS · another financial instrument/by exchanging financial instruments, or is the non-financial item readily convertible into cash?