3.14.2015

Ind AS 109 : Financial Instruments


Ind AS 109 is based on IFRS 9 which will replace IAS 39 and has not yet been made effective though earlier adoption has been allowed by IASB. This is one standard that would be adopted in early in India than rest of the world.The standards’ scope is broad. The standards cover all types of financial instruments, including receivables, payables, investments in bonds and shares, borrowings and derivatives.
They also apply to certain contracts to buy or sell non-financial assets (such as commodities) that can be net-settled in cash or another financial instrument.Ind AS 109 introduces single classification and measurement model for financial assets dependent on both:
  • The entity’s business model objective for managing financial assets;
  • The contractual cash flow characteristics of financial assets. 

Important Definitions

A financial asset is cash; a contractual right to receive cash or another financial asset; a contractual right to exchange financial assets or liabilities with another entity under potentially favorable conditions; or an equity instrument of another entity.

A financial liability is a contractual obligation to deliver cash or another financial asset; or to exchange financial instruments with another entity under potentially unfavorable conditions; or is a contract that will or may be settled in entity’s own instrument under certain circumstances.

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

A derivative is a financial instrument that derives its value from an underlying price or index; requires little or no initial net investment; and is settled at a future date.

Initial Recognition of Financial Assets and Liabilities
A financial asset or liability is recognized in the Balance Sheet when and only when, an entity becomes party to the contractual provisions of the instrument.

Initial Measurement of Financial Assets and Liabilities
A financial asset (except for certain trade receiveables) or liability is measured at its fair value. For those financial assets and liabilities not classified at fair value through profit or loss, directly attributable transaction costs should be added/subtracted to fair value.
The fair value of a financial instrument is normally the transaction price, that is, the fair value of the consideration given or received. However, in some circumstances, the transaction price may not be indicative of fair value.
Ind AS permits departure from the transaction price only if fair value is evidenced by a quoted price in an active market for an identical asset or liability (that is, a Level 1 input) or based on a valuation technique that uses only data from observable markets.

Classification of Financial Assets
Based on the entity’s business model objective for managing financial assets and the contractual cash flow characteristics of financial assets they are classified as financial assets measured at either amortized cost, fair value through profit or loss, or fair value through other comprehensive income.

Financial Assets Subsequently Measured at Amortized cost: 
To classify a financial asset as subsequently measured at amortized cost both of the below conditions must be met:
  • The financial assets held within a business model whose objective is to hold financial assets in order to collect contractual cash flows;
  • The contractual term of the financial asset give rise on specified dates to cash flow that are solely payments of principal and interest on the principal amount outstanding.
Such financial assets are subsequently measured at amortized cost using effective interest rate.

Financial Assets measured at Fair Value through Other Comprehensive Income (FVTOCI):
A financial asset should be measured at fair value through other comprehensive income if both of the following conditions are met:
  • The financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets; and
  • The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Such assets are subsequently measured at fair value with all gains and losses recognized in other comprehensive income Changes in fair value are not subsequently recycled to profit and loss. Dividends are recognized in profit or loss.

Financial Assets measured at Fair value through profit or loss (FVTPL)
A financial asset should be measured at fair value through profit or loss unless it is measured at amortised cost in or at fair value through other comprehensive income. However an entity may make an irrevocable election at initial recognition for particular investments in equity instruments that would otherwise be measured at fair value through profit or loss to present subsequent changes in fair value in other comprehensive income Note: the option to designate is irrevocable. Such financial assets are subsequently measured at fair value, with all gains and losses recognised in profit or loss.

Financial assets: Equity instruments
Investments in equity instruments are always measured at fair value. Equity instruments are those that meet the definition of equity from the perspective of the issuer as defined in Ind AS.

 Equity instruments that are held for trading are required to be classified as FVPL. For all other equities, management has the ability to make an irrevocable election on initial recognition, on an instrument-by-instrument basis, to present changes in fair value in OCI rather than profit or loss. If this election is made, all fair value changes, excluding dividends that are a return on investment, will be included in OCI. There is no recycling of amounts from OCI to profit and loss (for example, on sale of an equity investment), nor are there any impairment requirements.However, the entity might transfer the cumulative gain or loss within equity.

Financial liabilities
Financial liabilities are measured at the amortised cost using effective interest rate method unless they are classified as FTVPL. Financial liabilities are classified as FTVPL if they are designated at initial recognition as such (subject to various conditions), if they are held for trading or are derivatives (except for a derivative, that is, a financial guarantee contract or a designated and effective hedging instrument). For liabilities designated at FVPL, changes in fair value related to changes in own credit risk are presented separately in OCI. Amounts in OCI relating to own credit are not recycled to profit or loss even when the liability is de-recognised and the amounts are realised. However, the standard does allow transfers within equity.

Derivatives
Derivatives (including separated embedded derivatives) are measured at fair value. All fair value gains and losses are recognised in profit or loss except where the derivatives qualify as hedging instruments in cash flow hedges or net investment hedges.

Regular way purchase or sale of financial assets
Appendix A of Ind AS 109 defines a regular way purchase or sale of financial assets as follows:  A purchase or sale of a financial asset  under a contract whose terms require delivery of the asset within the time frame established generally by regulation or convention in the marketplace concerned.

Therefore, a contract that requires or permits net settlement of the change in the value of the contract is not a regular way contract. Instead, such a contract is accounted for as a derivative in the period between the trade date and the settlement date. A regular way purchase or sale of financial assets is recognised using either trade date accounting or settlement date accounting. Here trade date refers to the date that an entity commits itself to purchase or sell an asset whereas settlement date is the date that an asset is delivered to or by an entity.

Trade date accounting refers to
  • The recognition of an asset to be received and the liability to pay for it on the trade date,and derecognition of an asset that is sold, recognition of any gain or loss on disposal and the  recognition of a receivable from the buyer for payment on the trade date.
  • The recognition of an asset on the day it is received by the entity, and the derecognition of an asset and recognition of any gain or loss on disposal on the day that it is delivered by the entity.

 When using trade date accounting generally, interest does not start to accrue on the asset and corresponding liability until the settlement date when title passes.

When using settlement date accounting, an entity accounts for any change in the fair value of the asset to be received during the period between the trade date and the settlement date in the same way as it accounts for the acquired asset. In other words, the change in value is not recognised for assets measured at amortised cost; it is recognised in profit or loss for assets classified as financial assets measured at fair value through profit or loss; and it is recognised in other comprehensive income for investments in equity instruments accounted for using OCI option.


Derecognition of Financial Instruments
Derecognition is the term used for ceasing to recognise a financial asset or financial liability on an entity’s balance sheet. These rules are more complex.

Assets
An entity that holds a financial asset may raise finance using the asset as security for the finance or as the primary source of cash flow to repay the finance. Derecognition requirements of Ind AS 109 determine whether the transaction is a sale of the financial assets (and therefore the entity ceases to recognise the assets) or whether finance has been secured on the assets (and the entity recognises a liability for any proceeds received).
This evaluation can be straightforward. For example, it is clear with little or no analysis that a financial asset  is derecognised in an unconditional transfer of it to an unconsolidated third party, with no risks and rewards of the asset being retained.

Conversely, derecognition is not allowed where an asset has been transferred, but substantially all the risks and rewards of the asset have been retained through the terms of the agreement. However, the analysis may be more complex in other cases. Securitisation and debt factoring are examples of more complex transactions where derecognition will need careful consideration.

Liabilities
An entity may only cease to recognise (derecognise) a financial liability when it is extinguished–that is, when the obligation is discharged, cancelled or expires, or when the debtor is legally released from the liability by law or by the creditor agreeing to such a release.
An exchange between an existing borrower and lender of debt instruments with substantially different terms or substantial modification of the terms of an existing financial liability of part thereof is accounted for as an extinguishment.
The difference between the carrying amount of a financial liability extinguished or transferred to a 3rd party and the consideration paid is recognised in profit or loss.

Impairment of Financial Assets
The impairment requirements are applied to:
  • Financial assets measured at amortised cost (incl. trade receivables)
  • Financial assets measured at fair value through OCI
  • Loan commitments and financial guarantees contracts where losses are currently accounted for  under Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets
  • Lease receivables.

Ind AS 109 outlines a three-stage model (general model) for impairment based on changes in credit quality since initial recognition. It is based on changes in expected credit losses of a financial instrument that determine the recognition of impairment, and the recognition of interest revenue.

Stage 1 includes financial instruments that have not had a significant increase in credit risk since the initial recognition or have low credit risk at the reporting date. For these assets, 12-month expected credit losses (ECL) are recognised and interest revenue is calculated on the gross carrying amount of the asset (that is, without deduction for credit allowance). 12-month ECL result from default events that are possible within 12 months after the reporting date. It is not the expected cash shortfalls over the 12-month period but the entire credit loss on an asset weighted by the probability that the loss will occur in the next 12 months.

Stage 2 includes financial instruments that have had a significant increase in credit risk since the initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment. For these assets, lifetime ECL are recognised, but interest revenue is still calculated on the gross carrying amount of the asset. Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of the financial instrument. EPL are the weighted average credit losses with the probability of default (PD) as the weight.

Stage 3 includes financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime ECL are recognised and interest revenue is calculated on the net carrying amount (that is, net of credit allowance).ECL are a probability-weighted estimate of credit losses. A credit loss is the difference between the cash flows that are due to an entity in accordance with the contract and the cash flows that the entity expects to receive discounted at the original effective interest rate. Since ECL consider the amount and timing of payments, a credit loss arises even if the entity expects to be paid in full, but later than when contractually due.

The model includes some operational simplifications for trade receivables, contract assets and lease receivables as they are often held by entities that do not have sophisticated credit risk management systems. These simplifications eliminate the need to calculate 12-month ECL and to assess when a significant increase in credit risk has occurred.

For trade receivables or contract assets that do not contain a significant financing component, the loss allowance needs to be measured at the initial recognition as well as throughout the life of the receivable at an amount equal to lifetime ECL. As a practical expedient, a provision matrix may be used to estimate ECL for these financial instruments.

For trade receivables or contract assets which contain a significant financing component and lease receivables, an entity has an accounting policy choice. It can either apply the simplified approach (measuring the loss allowance at an amount equal to lifetime ECL at initial recognition and throughout its life), or apply the general model. As an exception to the general model, if the credit risk of a financial instrument is low at the reporting date, management can measure impairment using 12-month ECL, and so it does not have to assess whether a significant increase in credit risk has occurred.

Hedge Accounting
Hedging is the process of using a financial instrument (usually a derivative) to mitigate all or some of the risk of a hedged item. Hedge accounting changes the timing of recognition of gains and losses on either the hedged item or the hedging instrument so that both are recognised in profit or loss within the same accounting period, in order to record the economic substance of the combination of the hedged item and instrument. To qualify for hedge accounting, an entity must (a) formally designate and document a hedge relationship between a qualifying hedging instrument and a qualifying hedged item at the inception of the hedge, and (b) both at inception and on an ongoing basis, demonstrate that the hedge is effective.

There are three types of hedge relationships:

  •  Fair value hedge: A hedge of the exposure to changes in the fair value of a recognised asset or liability, or a firm commitment
  • Cash flow hedge: A hedge of the exposure to variability in cash flows of a recognised asset or liability, a firm commitment or a highly probable forecast transaction
  •  Net investment hedge: A hedge of the foreign currency risk on a net investment in a foreign operation

For a fair value hedge, the hedged item is adjusted for the gain or loss attributable to the hedged risk. That element is included in the statement of profit & loss where it will offset the gain or loss on the hedging instrument. For an effective cash flow hedge, gains and losses on the hedging instrument are initially included in other comprehensive income.

The amount included in other comprehensive income is the lesser of the fair value of the hedging instrument and hedge item. Where the hedging instrument has a fair value greater than the hedged item, the excess is recorded within the profit or loss as ineffectiveness. Gains or losses deferred in other comprehensive income are reclassified to profit or loss when the hedged item affects the statement of profit and loss.

 If the hedged item is the forecast acquisition of a non-financial asset or liability, the entity may choose an accounting policy of adjusting the carrying amount of the non-financial asset or liability for the hedging gain or loss at acquisition, or leaving the hedging gains or losses deferred in equity and reclassifying them to profit and loss when the hedged item affects profit or loss. Hedges of a net investment in a foreign operation are accounted for similarly to cash flow hedges.