Overview of AS 30 Financial Inst. & Derivatives

Flow of presentation

Overview of AS 30 Derivatives Financial Instruments Hedge Accounting Key Challenges

Overview – Scope & Principal Objective

Main objective is to establish principles for recognising and measuring financial instruments whose definition encompass most items of financial assets, financial liabilities in an entity's balance sheet

Derivatives and hedge accounting.

Derivatives : Thumb Rule

Examples of Underlying

Credit Rating

Other Variable

Interest Rates

Commodity Prices

Foreign Exchange rate

Indices

Thumb Rule : Underlying is any vaiable whose changes are observable or otherwise objectively verifiable

Underlying Examples

Derivatives -definition

Three characteristics

Fair value changes in response to the change in

underlying

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 chnages in market factors

Settled at a future date

Types Of Derivatives

Futures

Swaps

Der

ivat

ives

OptionsForward Rate Agreement

Forward Contracts

Embedded derivatives An embedded derivative is a Component of a hybrid instrument that also includes a non –derivative host contract

Bond which is convertible into equity Hybrid contract- Convertible bond

Host contract – Bond Asset Embedded Derivative-Conversion option

Lease agreement with inflation factor Hybrid Contract- Entire Lease Host Contract- Lease contract Embedded derivative- Adjustment for the inflation

Indian Entity A sells furniture to Indian Entity B in USD

Accounting for derivative contracts

The default accounting treatment for all derivative contract is

They are recorded on the balance sheet at fair value

Change in Fair value are recognized in the income statement.

Leads to unprecedented levels of P&L statement volatility.

Derivatives excluded from AS30 derivatives accounting rules

Contracts for ‘normal’ purchases and sales of non-financial items

Intended to meet purchases, sales or usage requirements

Designated for that purpose

Will be settled by delivery

Regular way purchases or sale of a financial assets

Delivery within a time frame established by regulation or convention in the market.

Apply trade date or settlement date accounting.

Financial Instruments

Definition:- A financial instrument is any contract that give rise to both:

(a) a financial assets of one entity and (b) a financial liability or equity instrument of another entity.

Sr. No. Assets Classifications

1 Investment in Equity Share Financial Assets

2 Trade & other Receivable Financial Assets

3 Cash & Cash Equivalents Financial Assets

4 Inventories Not a Financial Instrument

5 Income Taxes Not a Financial Instrument

6 Gold Not a Financial Instrument

Financial assets classification

Financial asset at fair value through profit and loss

Held to maturity Investment

Loans and receivables

Available for sale.

Restrictions on reclassification between categories except exceptional circumstances.

Financial assets classification-Cont

TradingHeld for Purpose of

Short term Profit

Originated by the enterprise ?

Loans and receivable originated

Intent and ability to hold to maturity?

Available for- sale

Held to Maturity

YesYes

NO

NO

YES

Yes

NO

NO

YES

Financial Instrument- Fair value & Accounting

XYZ Ltd Issue At Par 6 % debenture @1000/- each convertiable at the end of three yearDate Particulars Amount Rate Remarks

Year 1 Convrtiable Debenture 20 Lacs 6% 2000, 3 year Term issud at PAR

Market Rate for similar 9%debt without conv option

How to recognise Fair Value of Liabiliy & Equity Portions ??

Financial Instrument- Fair value & Accounting

Rs LacsParticulars Amt

Present Value of the Prinnciple - 20 lacs payable at the end of 3 years15.5

Present Value of Interest- Rs 1.20 lacs per annum 3.04

Total Liability Component 18.5

Net proceeds from the debenture issue 20

Net Difference towards equity component 1.51

Year Prn. O/s Interest@9% 6% paid Principle O/s closing

1 18.5 1.7 1.2 19.0

2 19.0 1.7 1.2 19.5

3 19.5 1.7 1.2 20.0

Conversion take place at end of 2nd year ??

Redemption take place at the end of 3rd year ??

Introduction –Concept of Hedging

Why 'Hedging' ?

A perfect hedge reduces investor's risk to nothing except for cost of the hedge.

Types of hedges

Fair Value hedges Hedge of exposure to changes in fair value of: - a recognized asset or liability; an unrecognised firm commitment; or an identified

portion of any of the above two; - that is attributable to a particular risk; and

- could affect P & L

Cash flow hedges Hedge of exposure to variability in cash flows that is - attributable to a particular risk associated with a recognized assets or liability or a

highly probable forecast transaction ( also an inter-company one) and

- could affect P & L

Hedge of Net investment in a foreign operation

Fair Value hedge accounting model

Measurement of hedge item

Fair Value

Fair Value with respect to risk being hedged

P & L

Changes in FVMeasurement of Derivaitves instrument

Cash flow hedge accounting model

Measurement of Derivative Instrument Changes in FV

Fair Value Equity

P & L

E ffective

Application of Hedge Accounting

Whether hedging instrument isa “ Qualified Instrument” ?

Whether “ Hedge Relationship”Is established ?

Does it Pass the “ Hedge Effectiveness” test ?

Apply hedge accounting

Adjust MTM in P/L Account

NO

NO

NO

NO

Cash Flow Hedge- AccountingImporter A Ltd hedge the forecasted import purchase cash flow through forward contract as per detail given below :

Date Particulars Amount(FC) Rate Remarks

20.06.07 Pur. contract 100000 Delivery March 08 & Due June 08

30.06.07 Fwd contract 100000 1.096 Cash flow hedged for June 08

Date Spot Rate Fwd Rate June 08 Fair Value30.06.07 1.072 1.096 031.12.07 1.08 1.092 (400) 31.03.08 1.074 1.076 (2,000) 30.06.08 1.072 1.072 (2,400)

Cash Flow Hedge- AccountingDate Particulars Debit Credit Remarks

30.06.07 No Change in fair value

31.12.07 Equity A/c 400 Being Loss on forward contract Forward Liability 400 parked in equity account

31.03.08 Equity A/c 1600 Being Loss on forward contract Forward Liability 1600 parked in equity account

31.03.08 Purchase A/c 107400 Being purchase recorded at spot Payable 107400 rate on 31.03.2008

31.03.08 Purchase A/c 2000 Being cuulative loss on fwd Equity A/c 2000 contract recognised in P&L A/c

30.06.08 Payable A/c 107400 Being settlement of payable at Bank A/c 107200 spot rateProfit & Loss A/c 200

30.06.08 P&L A/c 400 Being loss accountd on fwd Forward Liabiliy 400 contract

30.06.08 Forward Liabiliy 2,400 Being forward contract settledBank A/c 2,400

Cash Flow Hedge- AccountingHedge- Effectiveness??

Assuming actual purchase take place on 20th June 2008

Particulars 30.06.07 31.12.07 31.03.08 30.06.08

Spot Rate 1.072 1.080 1.074 1.072

Forward rate- 30 th June 08

1.096 1.092 1.076 1.072

Forward rate- 20 th June 08

1.091 1.086 1.070 1.068

FV of forward Contract

- (400) (2,000) (2,400)

FV of Cash flows (Purchase)

- 500 2,150 2,350

Effectiveness 80% 93% 102%

Evaluate whether the above hedging relationship is highly effective at the end of each period.

Hedge Accounting strict Criteria

Hedged Item and

Hedgeable Risks

Assesing effectiveness &

measuring

Hedging Instrument

Formal Documentation

Criteria for hedge accounting – documentation Hedge Relationship must be documented at inception

Risk management objective and strategy for the hedge

Identification of the hedging instrument

The related hedged item or transaction

The nature of the risk being hedged

How hedging instrument’s effectiveness will be assessed

Hedge relationship must be expected to be highly effective at inception and subsequent periods

Hedge effectiveness can be reliably measured

Actual Hedge effectiveness must be measured

In the case of hedging future cash flows, there must be a high probability of the case flow occurring

Hedging anticipated future cash flows is more difficult under AS 30

In the case of hedging future cash flows, there must be a high probability of that cash flow occurring

• Exposure to Variability in cash flows

- capex, floating interest rate, commitments and anticipated exposure

• High probability test to be satisfied on cash flow exposure

- Generally more than 90% probability

Scale of Probability of the forecasted transaction.

Special Rule: Cumulative gain and loss on hedging instrument remains in equity “ freeze mode” if test satisfied in a prior period

Hedge Accounting

Not Occuring Highly ProbableExpected to Occur

Firm Commitment

Hedge Effectiveness

Hedge Relationship must be expected to be highly effective at inception andIn subsequent periods

• General Principles

• Hedge effectiveness criteria

- highly effective at inception

- satisfy 80-125% effectiveness back test

Hedge accounting ineffectiveness in P&L

Hedge accounting ineffectiveness in P&L

125%

100%

80%

• Different notional and principal Amount for the derivatives And hedged item• Different maturity and re-set Dates• Currency differences• Credit Differences• Inclusion of Time Value

When a hedge no longer is effective

If the ongoing highly effective criterion fails, hedge accounting is discontinued.

- Hedge activity recorded prior to loss of effectiveness is not affected.

- The hedge does not qualify for special accounting prospectively from the last time it was proven effective.

- There is therefore a trade off between performing effectiveness testing frequently to ensure effectiveness and the administration effort into doing this frequently.

Hedge of a Net Investment in a Foreign Operation- Accounting Model

Measurement of Hedging Instrument

Measurement of Net Investment

Fx Transaction gains & Losses

Equity

Fx Transaction gains & Losses

Effective Portion

Special treatment for hedge accounting

Challenges :

Change in accounting ushered in by the standard can substantially affect the operation of entities

potential to accentuate earnings volatility especially since hedge accounting has been defined very rigorously

fair value measurement would pose a serious challenge in the valuation of financial instruments

need to revamp the MIS and technology capabilities of the entities that have to comply with AS 30 for which significant initial investment would have to be earmarked