Financial Instruments - Session 2 Jan 7

8/2/2019 Financial Instruments - Session 2 Jan 7

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Audit Planning Seminar

Kirtane&Pandit

Contents Definition and examples of financial instruments,

assets, liabilities and equity, financial liabilities vs.

equity and

Hybrid instruments

Classification of financial assets and liabilities

Initial recognition

Subsequent measurement principles

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assets, liabilities and equity, financial liabilities vs.equity

Hybrid instruments


Initial recognition


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Definitioncontract that gives rise to financial asset of one entity andfinancial liability / equity of another entity

Assets / liabilities that are not contractual financial instruments (e.g. taxrelated items they are not contractual, but statutory)


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In scope Out of scopeCash there is no present contractual right to receive cash

from these assets Physical assets (inventory, PPE owned or leased) Intangible assets (goodwill, patents)Gold bullion

Accounts receivable /payable

there is no cash inflow from these assets - Prepaidexpenses

Loans receivable / payable,including asset backedsecurities

Deferred revenue expenses and Most warranty obligations (as they are not fulfilledby payment in cash)** as they will not require outflow of cash

Investments debt andequity securities, commercial

debt deposits available ondemand or after a lapse oftime

Scoped out items as there is a separate accountingstandard for them

Interest in subsidiaries, joint ventures, associates Employee benefit plans Leases only certain aspects Share based payments Rights to receive reimbursements againstprovisions already made to meet certain obligations

per AS29 Obligations arising under insurance contracts


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In scope Out of scopeDerivative (asset / liability) Commodity derivatives

Financial guarantee contracts.....A contingent right andobligation meet the definition of a financial asset and afinancial liability, even though such assets and liabilities arenot always recognised in the financial statements.

Contracts betweenvendor and acquirer tobuy or sell an acquireeat a future date

Following types of loan commitments 1. If designated as FVTPL2. Which can be settled net3. To provide loans at below market rates of interest

Contract to buy or sell a non-financial item that can besettled net or if such a contract bears the characteristics ofa financial instrument


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The effective interest method is a method of calculating the amortised cost of afinancial asset or a financial liability.

The effective interest rate is the rate that exactly discounts estimated future cashpayments or receipts through the expected life of the financial instrument to thenet carrying amount of the financial asset or financial liability

When calculating the effective interest rate, an entity should estimate all cashflows of the financial instrument - all fees and points paid or received, transaction

costs, and all other premiums or discounts.

Formula for amortized costAmount @ Initial recognition XXX

- Principal repayments XXX+/ - Interest accrued (using effective interest method) XXX- / + Interest paid (using actual rate of interest) XXX- Impairment / uncollectibility losses XXX

Amortized cost XXX

Same as IRR


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Case 1 Liability with origination feesEntity S lends Rs. 1,000,000 to Entity A. The loan carries interest at 5% perannum payable annually and is payable in full after a period of five years, eventhough the market rate for similar loans is 8%. To compensate entity S for thebelow market rate of interest, entity A pays an origination fees of Rs. 120,000to entity S.

Case 2 LiabilityA bank issues bonds worth Rs.400,000 on 1st Jan 2004. The transaction costsdirectly attributable to the issue are Rs.20,000. The rate of interest is 6%payable annually and the bonds are redeemed on 31st December 2007 forRs.485,000. The effective rate of interest is 12%.

Indicate how the bond will appear in the books of the bank under the amortizedcost method, assuming that the company closes its books on 31st December.


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Case 2 Asset1/1/2005, XYZ Bank purchased a bond worth Rs.5,000. The bond attracts a 5%interest every year. It is redeemable on 31/12/2007 for Rs.5,830. The effectiverate of interest is 10%.


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1. Cash

2. Contractual right to receive cash or another financial asset

3. Equity investments of another entity

4. Contractual right to exchange financial assets or liabilities on potentiallyfavorable terms

5. Contract that will / may be settled in the Companys own equity instrumentsand is:

A derivative contract for a fixed number of entitys own equity instrumentsand it requires settlement other than by fixed amount of cash or anotherfinancial asset

A non-derivative Company is obliged to receive a variable number of theentitys own equity instruments


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1. Contractual obligation to deliver cash or another financial asset to anotherentity

2. Contractual obligation to exchange financial assets or liabilities on potentiallyunfavorable terms

3. Contract that will / may be settled in the Companys own equity instrumentsand is:

A derivative for a fixed number of entitys own equity instruments and itrequires settlement other than by fixed amount of cash or another financialasset

A non-derivative Company is obliged to deliver a variable number of theentitys own equity instruments


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An equity instrument is any contract that evidences a residual interest in the assetsof an entity after deducting all of its liabilities.

Examples

Non-puttable equity shares

Some types of preference shares Classification of preference shares

Warrants or written call options that allow the holder to subscribe for or purchasea fixed number of non-puttable equity shares in the issuing entity in exchangefor a fixed amount of cash or another financial asset. Case Study - Financialliability or equity?


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Obligation of an entity to issue or purchase a fixed number of its own equityinstruments in exchange for a fixed amount of cash or another financial asset.

share option that gives the counterparty a right to buy a fixed number of theentity s shares for a fixed amount of cash.

However, if such a contract contains an obligation for the entity to pay cash oranother financial asset, it also gives rise to a liability for the present value of the

redemption amount.

Entitys obligation under a forward contract to repurchase a fixed number of itsown shares for a fixed amount of cash


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Members shares in co-operatives ClassificationIf members do not have a right torequest redemption if either of thefollowing are true 1. Entity has an unconditional right to

refuse redemption

2. Laws, governing rules, bye-lawsprohibit redemption

Equity

Laws, governing rules, bye-lawsprohibit redemption only if redemptionwould cause the number of membershares or paid up capital to fall below a

specified level (which itself might bebased on a formula)

1. Members shares that would not beredeemed = Equity

2. Members share in excess of theprohibition = Liability

3. In case of changes to the paid upcapital subject to the redemptionprovision = transfer appropriateamount between liability andequity categories


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Discuss the accounting treatment in the following cases

Example 1- The governing bye-laws of the entity state that redemptions aremade at the sole discretion of the entity. However, the bye-laws further statethat approval of a redemption request is automatic unless the entity is unableto make payments without violating regulations regarding liquidity or reserves.

Example 2 - Law governing the operations of co-operatives, or the terms of thegoverning bye-laws of the entity, prohibit an entity from redeeming membersshares if, by redeeming them, it would reduce paid-in capital from membersshares below 75 per cent of the highest amount of paid-in capital from

members shares. The highest amount for a particular co-operative is Rs.1,000,000. At the balance sheet date, the balance of paid-in capital is Rs.900,000.

Ability to pay perregulations.

Intent to payper the

regulations


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Step 1 Calculate amount of LiabilityStep 2 Calculate amount of equity as a residual amount Equity = total amount of shares amount classified as liability

Step 3 Distributions to membersBifurcate the distributions on a pro-rata basis and treat the same as

interest (for the liability portion)

dividends (on the equity portion). Dividends that are classified as interest

should be presented in the P&L as a separate item.


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This example illustrates the P&L and balance sheet format that may be used by entities that do nothave equity as defined in AS 31. Other formats are possible.


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This example illustrates the balance sheet format that may be used by entities that have some equity asdefined in AS 31. Other formats are possible.


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Case Study - Entity A enters into the following contract -

Contract 1 is a written call option that gives the counterparty the right to buyequity of A for Rs.100 over a three-year period. The number of shares that willbe delivered to the counterparty on exercise will depend on when thecounterparty exercises the option.

If the counterparty exercises the option as of the first anniversary, 10 sharesare delivered, as opposed to 11 shares as of the second anniversary or 12shares as of the third anniversary. If the option is not exercised by the end ofyear three, the call option expires. If the option is exercised at any time duringthe three-year period, there is no further right to buy shares under the

arrangement.


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The number of shares that the instrument may be converted into only varieswith the passage of time and not with other variables, such as interest rates (i.e.the number of shares is fixed at inception of the contract).

The arrangement is therefore, considered to be an exchange of a fixed numberof shares for a fixed amount of cash.

Therefore, the premium received for writing the call option is credited to equity.


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Case Study - Entity A, which has a U.S. dollar functional currency, enters intothe following contract -

Contract 2 is a written call option that gives the counterparty the right to buyequity of A for US$100 over a three-year period. The number of shares that willbe delivered to the counterparty on exercise will depend on when the

counterparty exercises the option and the rate of LIBOR on that date.

If the counterparty exercises the option as of the first anniversary, the numberof shares delivered is 10 (1 + LIBOR), as opposed to 10 (1 + LIBOR)2 as ofthe second anniversary or 10 (1 + LIBOR)3 as of the third anniversary. If theoption is not exercised by the end of year three, the call option expires. If the

option is exercised at any time during the three-year period, there is no furtherright to buy shares under the arrangement.


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Contract 2 meets the definition of a financial liability because, if exercised, theissuer will deliver a variable number of shares for a fixed amount of cash. Eventhough the number of shares is predetermined by a specified index (in thiscase, LIBOR), the number of shares is not fixed in advance and varies as a resultof factors other than the passage of time (in this case, interest rates).

Therefore, the contract is not an exchange of a fixed number of shares for afixed amount of cash. As the contract meets the definition of a derivative inAS31, the written option must be initially categorized as FVTPL.

Equity instrument- definition


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Why is appropriate classification required? Gearing ratio

Impact on IS

Tax impact

Cumulative vs. non-cumulative shares

Type of preference rights ClassificationRedeemable sharesRedemption on a specific date Financial liability

Redemption at the option of the issuer Equity

Non-redeemable sharesIf distributions to holders (whether

cumulative or non-cumulative) are atthe discretion of the issuer

Equity


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equity

Hybrid instruments Classification of financial assets and liabilities

Initial recognition


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Hybrid financial instruments (have characteristics of both equity and liability)Initial recognition Separate the components of a financial instrument as follows -

(a) part that creates a financial liability

(b) part that grants an option to the holder of the instrument to convert itinto an equity instrument

Value of any derivative features (such as a call option) embedded in the

compound financial instrument is included in the liability component.

Classification does not change subsequent to initial recognition

Subsequent measurement On conversion of a convertible instrument at maturity,

The liability component gets transferred to equity.

The original equity component remains as equity (although it may betransferred from one line item within equity to another).

There is no gain or loss on conversion at maturity.


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To calculate cash outflow, use the actual rate of interest

For PV, use the discount rate of similar debt instruments with no conversionoption

Cash outflow on the compound instrument at PV $$$

Cash to be paid at maturity @PV XXX

Add Periodic interest payments @ PV XXX

Total Cash outflow on the compound instrument at PV =liability portion of the compound financial instrument XXX

Equity portion (balancing figure) XXX

Total proceeds from issue XXX


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On 1 October 2009 ABC issued 5 million loan notes that had a value of Rs.1 pernote. The issue costs were 3%.

Each note holder will receive interest of 5 paise per note on 30 September ofeach year starting on 30 September 2010. The loan notes are repayable on 30September 2019 at Rs.120 per note.

As an alternative to repayment the loan note holders can elect to exchange theirnotes for shares in ABC. On 1 October 2009 the credit rating of ABC was suchthat it would have had to offer investors in non-convertible loan notes a rate ofreturn of 9% per annum on any investment. The impact of issue costs wouldincrease the effective interest rate on such loan notes to 945%.

Discuss the presentation of various items in the balance sheet of ABC.


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Discount factors 10th year Cumulative

0.42 6.42

Cash flows on account of PV

Interest 250 1,605

Principal repayment 6,000 2,520

PV of cash flows = Liability 4,125 123.75 4,001 A

Equity (balancing figure) 875 26.25 849 B

Total proceeds 5,000 150 4,850

Balance sheet on the date of issue Balance sheet at year end

Liability (net of issue costs) 4,001 A Liability

Equity (net of issue costs) 849 B Opening balance 4,001

+ Accrued interest at 9.45% 378.12

- Interest paid -250

Closing balance 4,129

Equity 849 B

Pro-rata allocation of

issue costs Net


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Early retirement - Consideration and any transaction costs paid should be allocated to the

separate components of liability and equity.

After allocation to respective components,

Gain or loss on liability component recognize in the P&L account.

Gain or loss on equity component adjust against the original equity

component and transfer the balance to reserves and surplus.

Amendment of terms to induce early retirement - On the date the terms are amended, calculate the difference in the fair values,

between

a) Amount the holder will receive due to early retirementb) Amount the holder would have received under the original terms

Recognize this difference as a loss in the P&L account

A dit Pl i S i


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assets, liabilities and equity, financial liabilities vs

equity

Hybrid instruments

Classification of financial assets and liabilities Initial recognition of financial assets and liabilities


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Fair value

through P&L

Loans and

receivable

Held to

Maturity

Available for

sale

Financial

assetsFair value

through P&L

Other

Financial

liabilities


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1. FV through P&L Trading securities held for short term

Part of group of financial assets (portfolio) that are managed on a FV basisand for which there has been recent evidence of short-term profit taking

Derivatives (other than hedging instruments and financial guaranteecontracts)

Classification can be used to reduce an accounting mismatch

2. Loans and receivables Non derivative financial assets with fixed payment terms

Not quoted in active market

An asset that could be classified as a loan or receivable, may designated as afinancial asset at fair value through profit or loss, or available for sale.

3. Available for sale Non derivative financial assets with fixed payment terms that are not quoted

in active market and for which the holder may not recover substantially all ofits initial investment, other than because of credit deterioration

Residual category

Documentationrequired


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4. Held to maturity (HTM) Non derivative financial assets with fixed payment terms and maturity

Ability and intent to hold till maturity Category NA for investment in equity securities or share options, warrants

and perpetual debt instruments

An entity does not have the intention to hold to maturity if:a) the entity intends to hold the financial asset for an undefined period;

b) the entity stands ready to sell the financial asset in response to changes inmarket interest rates or risks, liquidity needs, changes in the availability ofand the yield on alternative investments, changes in financing sources andterms or changes in foreign currency risk; or

c) the issuer has a right to settle the financial asset at an amount significantlybelow its amortized cost.

Instruments that have been pledged as collateral or are subject to a repurchaseagreement or securities lending agreement can be classified as HTM, as long as

the entity expects to be able to maintain or recover access to the instruments.


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4. Held to maturity (HTM)

Tainting provision this category cannot be used, if the Company has sold amore than insignificant amount of HTM investments before maturity in thecurrent or immediately preceding 2 years. In such case, all remaining assetsshould be reclassified as AFS.

What is insignificant has not been defined

Exceptions to the tainting provision sales or reclassifications that

i. are so close to maturity or the financial asset's call date (e.g. less than 3months before maturity) that changes in the market rate of interest wouldnot have a significant effect on the financial assets fair value; or

ii. occur after the entity has collected substantially all of the financial asset'soriginal principal through scheduled payments or prepayments; or

iii. are attributable to an isolated event that is beyond the entitys control, isnon-recurring and could not have been reasonably anticipated by the

entity.


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4. Held to maturity (HTM) tainting provisions - Exceptions to the taintingprovision sales or reclassifications that are due to

iv. a significant deterioration in the issuers creditworthiness that was notanticipated during purchase

v. a change in statutory or regulatory requirements significantly modifyingeither what constitutes a permissible investment or the maximum level of

particular types of investments, thereby causing an entity to dispose of aheld-to-maturity investment.

vi. a significant increase in the industrys regulatory capital requirements thatcauses the entity to downsize by selling held-to-maturity investments.

vii. a significant increase in the risk weights of held-to-maturity investmentsused for regulatory risk-based capital purposes


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Case 1 HTM yes or no?Entity A purchases a five-year equity-index-linked note with an original issueprice of Rs.10 at a market price of Rs.12 at the time of purchase. The noterequires no interest payments before maturity.

At maturity, the note requires payment of the original issue price of Rs. 10 plusa supplemental redemption amount that depends on whether a specified share

price index exceeds a predetermined level at the maturity date.Entity A has the positive intention and ability to hold the note to maturity. CanEntity A classify the note as a held-to-maturity investment?

Case 2 Loans and receivables yes or no?Banks make term deposits with the Reserve Bank of India or other banks. The

proof of deposit (such as certificate of deposit/ receipt) may or may not benegotiable. Even if negotiable, the depositor bank may or may not intend to sellit.

Would such a deposit fall within loans and receivables?


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Case 1 HTM yes or no?Yes. The note can be classified as HTM because it has

fixed payment of Rs. 10

fixed maturity and

Entity A has the positive intention and ability to hold it to maturity.

However, the equity index feature is an embedded derivative, which must beseparated from the HTM investment. The purchase price of Rs. 12 is allocatedbetween the host debt instrument (HTM investment) and the embeddedderivative.

For example, if the fair value of the embedded option at acquisition is Rs.

4, the host debt instrument is measured at Rs. 8 on initial recognition. In thiscase, the discount of Rs. 2 that is implicit in the host bond (principal of Rs. 10minus the original carrying amount of Rs. 8) is amortised to the statement ofprofit and loss over the term to maturity of the note using the effective interestmethod.


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Case 2 Loans and receivables yes or no?Such a deposit meets the definition of loans and receivables, whether or not theproof of deposit is negotiable, unless the depositor bank intends to sell theinstrument immediately or in the near term, in which case the deposit isclassified as a financial asset held for trading.


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Case 1 Can an entity apply the tainting provisions for HTM classification separately todifferent categories of HTM financial assets, such as debt instrumentsdenominated in Indian Rupees and debt instruments denominated in a ForeignCurrency?

Case 2 Can an entity apply the tainting provisions for HTM classification separately toheld-to-maturity financial assets held by different entities in a consolidatedgroup, for example, if those group entities are in different countries withdifferent legal or economic environments?


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1. FV through P&L Held for trading purpose

Part of group of financial assets (portfolio) that are managed on a FV basisand for which there has been recent evidence of short-term profit taking

Derivatives (other than hedging instruments and financial guaranteecontracts)

Classification can be used to reduce an accounting mismatch

2. Other liabilities Residual category



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equity and hybrid instruments


Initial recognition Subsequent measurement principles

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Examples stamp duty, brokerage, registration /legal fees, professional fees,printing costs

Treatment -1. If the cost is directly related to the equity issue and otherwise could have

been avoided, deduct from equity.2. Expense if it relates to abandoned equity transaction.3. If the cost is directly related to the issue classified as a liability and

otherwise could have been avoided, deduct from liability. This will changethe effective rate of interest on the liability.

4. Compound financial instrument allocate transaction costs betweenequity and liability portion in the ratio of proceeds

5. Allocate in a rational manner, if costs relate to more than 1 transaction.


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FV thru P&L Loans and receivables Held tomaturity Available forsaleInitial

measurement

@ FV

Expensetransaction

costs

@ FV +/ - transaction costs

Short term receivables withno stated interest rate

should be measured at theoriginal invoice amount, ifthe effect of discounting isimmaterial

@ FV + / -transactioncosts

@ FV + / -transactioncosts


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FV thru P&L Loans and receivables Held tomaturity Available for saleSubsequent

measurement

@FV,

differenceto P&L

Amortized cost, usingeffective interestmethod

Short term receivableswith no stated interestrate should bemeasured at theoriginal invoiceamount, if the effect ofdiscounting is

immaterial

Amortizedcost,usingeffective

interestmethod

@FV, difference toreserves andsurplus

If the AFS assethas fixed ordeterminablepayments,transaction costsare expensed usingeffective interest

method; otherwise

Transaction costsare expensed uponimpairment orderecognition


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Yes, only when all the following conditions are satisfied - Equity investments do not have a quoted price in an active market The fair value cannot be reasonably measured

In such cases, any derivatives that are linked to the instrument should also bestated at cost.

Applicability only to Investments in equity instruments / derivative instruments linked to them


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Assess for impairment on each balance sheet date. Impairment loss shouldbe recognized only if there are loss events.

E.g. of loss events

financial difficulty of borrower, including bankruptcy filing

national and economic conditions

active market does not exist for the security any longer.

Accounting treatment differs based on how the asset is accounted for.

Assets that are carried at cost Impairment loss (IL) = carrying amount PV of estimated future cash

flows, discount rate to be used is the market rate of return for a similarinstrument.

IL debit to P&L

IL cannot be reversed


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Loans andreceivables Held to maturity Available for sale

Impairmenttestingrequired?

Yes Yes Yes

IL amount Carrying amount NPV of future cashflows.

Use the effective interest rate computedat initial recognition for discounting

Short term receivables carried at originalinvoice price IL = Carrying amount undiscounted future cash flows.

Acquisition cost current fairvalue

Accounting forIL

Debit to profit and loss account, eitherdirectly or through reserve account

Transfer fromequity account toP&L

No impairmenttesting required forFV thru PL


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ABC Company delivered a quantity of components to a customer on 30 June2009. The invoiced amount was Rs.500,000. ABC Company expected to receivepayment on 31 August 2009.

ABC Company received no cash and on 30 September 2009 was informed thatthe customer has major cash flow problems as a result of the failure of one of its

projects sometime in August 2009. It has agreed to allow the customer until 30September 2010 to settle the debt, by which time it is confident the cash flowproblems will be resolved.

ABC Company expects annual interest of 6% on any money it lends out.

Discuss the accounting treatment at each quarterly reporting date beginningSeptember 2009.


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Loans andreceivables Held tomaturity Available for sale

Reversal of IL The reversal should not resultin a carrying amount of the

financial asset that exceedswhat the amortised cost wouldhave been had the impairmentnot been recognised at thedate the impairment isreversed.

Not possible for equityinstruments.

For debt instruments,reversal is possible.

Accounting for ILreversal

Credit to P&L Credit P&L (for debtinstruments only)

No impairmenttesting required forFV thru PL


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FV thru P&L Loans andreceivables Held to maturity Available forsale1. Changes in FV

2. Transaction

costs

3. Interest,dividend income

4. Gain / loss on

derecognition

1. Interest /dividendincome

2. Gain / loss onderecognition

3. Impairment loss

1. Interest, dividendincome

2. Gain / loss onderecognition

3. Impairment loss

1. Interest,dividendincome

2. Gain / losspreviouslytaken to OCIis trf to SOCIon sale

3. Impairmentloss


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FV thru PL assets / liabilities cannot be reclassified into or out of thiscategory

HTM any reclassification out of this category should be to AFS; resultinggain or loss should be recognized in equity.

Investments that were initially classified at cost and for which fair value lateron becomes available resulting gain or loss should be recognized in equity(if AFS) or in P&L.

AFS Investments that need to be carried at cost or amortized cost-

In case asset will be carried forward at amortized cost- transfer gain or

loss to P&L using effective interest method In case asset will be carried forward at cost- gain or loss amount remains

in equity


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Category FV thru PL measure at FV, unless it is a derivative liability that islinked to unquoted investments stated at cost.

Short term payables with no stated interest rate should be measured at theoriginal invoice amount, if the effect of discounting is immaterial.

When a transfer of a financial asset does not qualify for derecognition -initially recognize financial liability for the consideration received.

Other liabilities at fair value less transaction costs.


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Category FV thru PL measure at FV, unless it is a derivative liability that islinked to unquoted investments stated at cost.

Short term payables with no stated interest rate should be measured at theoriginal invoice amount, if the effect of discounting is immaterial.

When a transfer of a financial asset does not qualify for derecognition -recognize any expense incurred on the liability.

When an entity continues to recognise an asset to the extent of its continuinginvolvement, the entity also recognises an associated liability. Accountingfor the liability should follow accounting for the asset i.e. fair value or

amortized cost, depending upon how the asset is accounted for.


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Financial guarantee contracts subsequently measure at higher of Amount determined in accordance with AS29

Book value less cumulative amortization if any (applicable only when theliability is not measured at FV thru PL)

Commitment to provide a loan at below-market rate of interest same as

above


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Documents

Financial Instruments - Session 2 Jan 7