Financial Instruments EIRC, Kolkata Arif Ahmed June 2018

Financial Instruments Standards Issues Presentation, Recognition and derecognition, Hedge accounting, Disclosures Three standards Ind AS 32: Defines financial instruments and segregates liability from equity Ind AS 109: Specifies recognition, measurement, and conditions of hedge accounting Ind AS 107: Specifies disclosure requirements

Financial Instruments Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another.

Financial Assets Examples of financial assets Cash Equity instrument of another entity Contractual right to receive cash or another financial asset or to exchange with entity financial assets or financial liabilities under potentially favourable conditions; • Certain contracts settled in entity’s own equity.

Financial Liabilities Contractual obligation to deliver cash or another financial asset or to exchange financial assets or financial liabilities under potentially unfavourable conditions; Certain contracts settled in entity’s own equity

Equity Instruments Contract evidencing residual interest in the assets of an entity after deducting all its liabilities.

Presentation Issues: Ind AS 32 Presentation (from issuer’s perspective) sets out principles for – Debt v/s Equity Compound Financial Instruments Treasury shares; Offset financial assets and financial liabilities Complements of Ind AS 109 and Out of Scope Associates, JVs, Employee benefits, Insurance Contracts, Share-based payment

Presentation: Liability and Equity Compound financial instrument: Convertible bond, its allocation is done as fair value of the instruments less fair value of liability and the residual is equity. Transaction costs relating to the above are allocated in the proportion of proceeds Treasury shares: They are deducted from equity. No gain or loss is recognised in profit and loss on acquisition

Presentation: Liability and Equity Interest, dividends, losses and gains: Relating to Financial Assets or Financial Liabilities are recognised in P/L. Relating to distribution to equity holders debited to equity, net of tax effect. Transaction costs relating to equity are deducted from equity

Presentation: Offsetting There is a legally enforceable right to set off and intends to settle on net basis or realise the assets and settle the liability simultaneously Master netting agreement provides net settlement only on default and hence in the general course, the assets and liability are not netted off.

Classification of Financial Instruments Old Model – What has changed IAS 39 IndAS 109 Scope No Change Recognition / Derecognition Classification of financial assets Four categories: Fair value through profit or loss (FVTPL) Loans and receivables Held to maturity (HTM) Available-for-sale financial assets. Three categories: Amortised cost Equity investments at fair value through OCI Fair value through profit or loss (FVTPL).

Classification of Financial Instruments Old Model – What has changed IAS 39 IndAS 109 Classification of financial liabilities Two categories: Fair value through profit or loss (FVPTL) Amortised cost. No change to categories. Fair value changes for changes in entity’s own credit risk are to be recognised in OCI Hybrid contracts Bifurcation if embedded derivative is not closely related to the host contract and the entire contract is not measured at FVTPL. No bifurcation for financial assets. Bifurcation remains for financial liabilities and contracts for non-financial assets and liabilities

Classification of Financial Instruments Amortised Costs - Basics A financial asset can be classified as ‘financial assets at amortised cost’ only if it meets both the following two criteria: The business model of holding the asset is to collect contractual cash flows ( ‘hold-to-collect’ business model test) Contractual cash flows arising from the financial asset are solely payments of principal and interest on the principal amount outstanding on specified date (‘SPPI’ contractual cash flow characteristics test). Examples of assets likely to come under the classification Trade receivables; Loan receivables Investments in government bonds not held for trading; Investments in term deposits at standard interest rates.

Classification of Financial Instruments Amortised Costs – Computational Aspect Amortisation is a method of appropriating a block amount over its life and the most common application of the same is computation of effective interest rate. Effective interest rate is the amount that precisely discounts the principal and interest cash flows to the initial cash flow in a way that the interest rate will amortise any premium, discount, or transaction costs. EIR can be easily computed by IRR function in any standard spread sheet Fixed Rate Bond Example: Consider a 5 year bond issued at MU1500 with coupon earning of MU 100, MU 125, MU150, MU 175, and MU 200 in five years. The EIR can be computed as 1500 = 100 (1+𝐸𝐼𝑅) + 125 (1+𝐸𝐼𝑅) 2 + 150 (1+𝐸𝐼𝑅) 3 + 175 (1+𝐸𝐼𝑅) 4 1500+200 (1+𝐸𝐼𝑅) 5 The equation will result in EIR = 9.69%

Classification of Financial Instruments Amortised Costs – Computational Aspect: Fixed Rate Bond The amortisation schedule using the EIR will be as following: The EIR may be computed in spread sheet by using the IRR Op. Balance Amortised cost Interest @ 9.69% Cash Flow Cl. Balance Amortised cost Year 0 1500 Year 1 145 100 1545 Year 2 150 125 1570 Year 3 152 1572 Year 4 175 1549 Year 5 200

Classification of Financial Instruments FVTPL and Amortised Costs – Illustration A company purchased a five-year bond on 1 January 20X2 at a cost of MU 5m with annual interest of 5% payable on 31 December annually. At the reporting date of 31 December 20X2 interest has been received as expected and the market rate of interest now stands at 6%. The treatment of the same as FVTPL; and at amortised cost

Classification of Financial Instruments FVTPL and Amortised Costs – Illustration A company purchased a five-year bond on 1 January 20X2 at a cost of MU 5m with annual interest of 5% payable on 31 December annually. At the reporting date of 31 December 20X2 interest has been received as expected and the market rate of interest now stands at 6%. Treatment as FVTPL is as follows On 31 Dec 20X2 the asset will be taken at FV of MU4.8267, the difference of MU 0.1733 being charged to profit and loss Year Cash Flow DF at 6% PV 31 Dec 20X3 0.25 0.9434 0.2358 31 Dec 20X4 0.8900 0.2225 31 Dec 20X5 0.8396 0.2099 31 Dec 20X6 5.25 0.7921 4.1585 4.8267

When at Amortised Cost Business Model Test Contractual Cash Flow

Financial Assets Business Model – to collect contractual cash flows ‘Hold-to-collect’ business model is one where the reporting entity plans to hold the financial asset and collect all contractual cash flows from the same Trade receivables held by a trading company would match the ‘hold-to-collect’ business model, if the entity is expected to collect the cash flows from those IndAS 109 does not require holding till maturity as a binding condition. The model may still exist if the entity infrequently sells off few asset from the “hold- to-collect” portfolio before maturity Under HTM category of IAS 39 this was prohibited and called for a 2 year ban

Financial Assets Business Model – to collect contractual cash flows Deciding on fulfilment of “hold to collect” criteria? The decision is based on overall management objective and not on instrument- to-instrument basis. If there are different objectives for different portfolio, the key management person will decide the level at which the test is to be applied. A bank may hold assets for trading as well till maturity

Financial Assets The Solely Payments of Principal and Interest (SPPI) criterion This test confirms whether the cash flows from the assets are solely payments of principal and interest on the principal amount outstanding on specified dates as agreed upon in the contractual terms Interest is considered to be compensation for Time value of money Credit risk If the repayment includes compensation for any other element, SPPI test fails That would make pure debt instruments qualify under SPPI

Financial Assets FVOCI Category for equity instruments All investments in equity of listed and unlisted companies, will be measured at fair value. Equity investments not held for trading can be irrevocably classified at initial recognition as “fair value through other comprehensive income” (FVTOCI), Subsequently all changes in fair value will be recognised in OCI while dividends will be recognised in profit or loss. On disposal, cumulative fair value changes will remain in OCI, though reporting entities may transfer amounts between reserves within equity – viz. FVTOCI reserve and retained earnings, both forming a part of equity

Financial Liabilities Categories for Financial Liabilities IndAS 109 classification of financial liabilities is similar to that under IAS 39 Financial liabilities at amortised cost subsequently measured at amortised cost using the effective interest method. Financial liabilities as at fair value through profit or loss (FVTPL). subsequently measured at fair value with changes in fair value recognised in P&L All financial liabilities are to be measured at amortised cost unless either: It is required to be measured at FVTPL because it is held for trading or The entity elects to measure it at FVTPL (using the fair value option). Major change lies in presentation of changes in fair value of financial liabilities designated as FVTPL arising out of change in own credit status This is to be shown under OCI

Financial Liabilities Categories for Financial Liabilities: Fair Value Option Like in case of financial assets, IndAS 109 permits designating financial liabilities at FVTPL if any of the following apply: If electing fair value eliminates or reduces an accounting mismatch Such mismatch occurs when gains and losses on two items exposed to the same fair value risk are not recognised consistently. For example, if fair value option is not available, a financial asset would be treated as FVTPL and related liability will be measured at amortised cost. Example: Entity holds a fixed-rate loan receivable that it hedges with an interest rate swap that changes the fixed rates for floating rates If a specific financial liability is a component of a group of financial liabilities or financial assets and liabilities which is managed on a fair value basis A hybrid contract containing an embedded derivative that would otherwise be required to be separated.

Financial Instruments –IndAS 109 Classification and Measurement Financial Assets at Amortised Cost Fin. Assets at FVTPL Equity Instruments through FVTOCI Debt Instrument? Derivative? Equity? Hold to collect? Cash flows for interest & capital? Designated as FVTPL? Elected to use FVTOCI? Out of scope YES NO Fin. Assets at FVOCI Both hold and sell?

Derivatives A derivative is a financial instrument or contract The value changes in response to changes in an underlying interest rate, exchange rate, commodity price, security price, credit rating, etc. Settlement takes place at a future date.

Contract Decision Tree Financial Item Non Financial Item Settled by cash, financial instrument or exchanging financial instrument? Is the contract a derivative? Underlying asset, little or no investment, and likely settlement Is it written option with premium? Own use exempt? Fair Value Trough Profit & Loss Yes No Host contract out of scope Qualify for own use? Is hedge accounting possible? Cash flow hedge through equity Includes embedded derivative? Accrual Accounting Fair value host and derivative

Derivatives: Recognition Initial Recognition Transaction Price Fair value at each reporting date Report changes in fair value in P/L unless being considered under hedge accounting Changes in fair value recorded in Other Comprehensive Income to the extent hedge is effective

Subsequent Recognition P&L Not relevant (unless impaired) Held-to-maturity investments Amortised cost (effective interest rate) Loans and receivables Available-for-sale Fair value Financial assets (HFT) at fair value through profit or loss Derivatives Financial liabilities at fair value through profit or loss Other liabilities OCI Instrument Measurement Value changes

Exemption for Own Use Contracts entered into and continued to receive or deliver non-financial asset are excluded from derivative accounting Accounted for as executory contract, an off-balance sheet treatment until completed Practice of settling similar contracts net by paying cash or another financial instrument may disqualify an entire group from being classified for ‘own use’

Exemption for Own Use Qualification for this exemption requires that three conditions are met: contracts are entered into and continue to meet own purchase, sale or usage criteria contracts are designated for this purpose at inception and contracts are settled by physical delivery Own use is not an elective measure and it cannot be selectively fair valued

Hedge Accounting Hedge accounting is permitted where there is a designated hedging relationship between a hedged item and a hedge instrument. Hedge accounting seeks to offset the Gains and losses of changes in fair value of the hedging instrument and Gains and losses of changes in fair value of hedged asset Gains and losses on hedge instrument and hedge asset is recognised in the same accounting period

Hedge Accounting: Key words Hedging Designating one or more hedging instruments so that the change in the fair value fully or partially offsets the fair value or cash flows of a hedged item Hedged item An asset, liability, form commitment, or forecasted future transaction that Exposes the entity to risk of changes in fair value or future cash flow and Designated as being hedged

Hedge Accounting: Key words Hedging Instrument Designated derivatives or another financial assets or liability whose fair value or cash flows are expected to offset changes in the fair value or cash flow of a designated hedge items. A non derivative financial asset or liability may be designated as hedging instrument only for hedging the risk of foreign exchange rate fluctuation Hedge effectiveness The degree to which the changes in fair value or cash flows of hedged item attributable to hedge risk are offset by changes in fair value or cash flows of the hedging instrument

Hedge Accounting: Conditions A hedging relationship qualifies for hedge accounting if all of the following conditions are met: Hedging relationship consists only of eligible hedging instruments and eligible hedged items At the inception of the hedge there is formal documentation setting out the hedge details including Identification of hedge item, hedge instrument, Nature of risks to be hedged, Method of assessing effectiveness of hedging instrument

Hedge Accounting: Conditions The hedging relationship meets all of the hedge effectiveness criteria is expected to be highly effective There is an economic relationship between the hedged item and hedging instrument Effect of credit rusk does not dominate the value changes that results from that economic relationship viz, value changes because of credit risk does not overshadow the value changes arising from the economic relationship The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges, and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. This is often determined by the risk manager

How Hedging Works: Illustration Consider a company which owns an inventory of 20000 Kg of iron costing MU 400,000 as on 1 Dec 20x3. In order to hedge the risk arising out of fluctuation in market value of the iron the company signs a Futures contract to deliver 20000 Kg of iron on 31 March 20x4 at the price of MU 22 per kg. The market price of iron on 31 Dec 20x3 is MU 23 per kg and the futures price of delivery on 31 March 20x4 is MU 24 per kg

Impact of Hedge Accounting Without hedge accounting Futures contract is a derivative is to be fair valued and loss on futures contract will be recognised in PL DEBIT Profit or Loss [20,000 x (24-22)] 40,000 CREDIT Financial Liability 40,000 With hedge accounting Loss is recognised in Profit or Loss and inventory revalued to fair value Fair value on 31 Dec 20x3 460,000 Less: Original cost 400,000 GAIN 0060,000 Gain is also recognised in Profit or Loss DEBIT Inventory 60000 CREDIT Profit or Loss 60000 The net effect on Profit or Loss is a gain of MU 20000

Types of Hedge There are three types of hedge Fair value hedge Cash flow hedge Hedge of net investment in foreign subsidiary

Fair Value Hedge This hedges exposure to changes in fair value of Recognised assets or liability Firm commitment Fair value hedge includes Assets and liabilities denominated in foreign currency Fixed rate bond,

Fair Value Hedge: Accounting Treatment Hedging Instrument The gain or loss from re-measuring the hedging instrument at fair value will be recognised in Profit or Loss If the hedging instrument hedges an equity instrument measured at FVTOCI gain or loss will be recognised in OCI Hedged Item Gain or loss attributable to hedged risk should adjust the carrying amount of the hedged item and recognised in PL If the hedged item is a financial asset mandatorily fair valued through OCI, the gain or loss will be recognised in PL If the hedged item in an investment in equity instrument measured at FVTOCI the gains and losses on both hedged investment and instrument will be recognised in OCI

Cash Flow Hedge Hedges exposure to variability in cash flow Cash flow hedge includes Anticipated sale or similar highly probable forecasted transaction Future interest payment on variable rate bond

Cash Flow Hedge: Accounting Treatment Hedging instrument Portion of the gain or loss on an effective hedging instrument, upto the value of loss or gain of the cash flow hedge, should be recognised in OCI and directly in equity through SOCE The ineffective portion of the gain or loss on the hedging instrument should be recognised in Profit or Loss When a hedging transaction results in the recognition of an asset or liability, changes in the value of the hedging instrument recognised in equity either Are adjusted against the carrying value of the asset or liability Affect the profit and loss at the same time as the hedged item

Net Investment in Foreign Subsidiary Hedge Hedges value of exposure to exchange rate changes associated with foreign operation Treated as cash flow hedge

Impairment of Financial Assets A financial asset is credit impaired when one or more events have occurred that have a detrimental impact on the estimated future cash flows of the financial asset. Indications of impairment of impairment includes Significant financial difficulty of the issuer A breach of contract such as a default in interest or principal payment The lender granting a concession to the borrower that the lender would not otherwise consider, for reasons relating to the borrowers financial difficulty It becomes probable that the borrower will enter bankruptcy The disappearance of an active market for that financia asset because of financial difficulties The purchase or origination of a financial asset at a deep discount that reflects incurred credit losses

Expected Credit Loss Model The impairment model is based on expected losses unless the earlier approach of providing for incurred losses. The financial statements should reflect the general pattern of deterioration. This is a forward looking model. The key concepts are Credit losses: Expected shortfall in contractual cash flows Expected credit losses: Weighted average of credit losses with the respective risks of a default used as the weights Lifetime Expected Credit losses: Expected credit losses that result from all possible default events over the expected life of a financial instrument Past Due: When counterparty fails to make a payment on a contracted date Purchased or originated credit impaired financial assets: Assets that are credit impaired at initial recognition

Scope of the impairment requirements Credit Loss Difference between all contractual cash flows due to an entity and expected cash flows, discounted at the original effective interest rate or credit-adjusted EIR for purchased or originated credit-impaired financial assets. Scope under IndAS 109 Financial assets measured at FVOCI Lease receivables Trade receivables and contract assets Loan commitments and financial guarantee contracts not measured at FVTPL Financial assets measured at amortised cost Out of scope Equity Investments Financial instruments measured at FVTPL Para 5.5.1: an entity shall recognise a loss allowance for expected credit losses on a financial asset that is measured in accordance with paragraphs 4.1.2 (amortised cost) or 4.1.2A (fair value through other comprehensive income), a lease receivable, a contract asset or a loan commitment and a financial guarantee contract to which the impairment requirements apply in accordance with paragraphs 2.1(g), 4.2.1(c) or 4.2.1(d).

Impairment of Financial Assets The three stage impairment model Change in credit risk since initial recognition Interest recognition Gross basis ‘Under-performing’ ‘Non-performing’ Impairment recognition 12-month expected credit losses Lifetime Stage 1 Stage 2 Stage 3 On significant increase in credit risk occurs Net basis ‘Performing’ Status

Impairment of Financial Assets The three stage impairment model The broad process of working of the model is as following: PD Thresh-hold Impairment Investment Grade Non- Investment Grade Default Probability of Default

Impairment of Financial Assets Expected loss model Credit loss This is the difference between all contractual cash flows due to an entity and cash flows that the entity expects to receive, discounted at the original effective interest rate or credit-adjusted EIR for purchased or originated credit-impaired financial assets. Expected Credit Loss This is weighted average of credit losses with the respective risks of a default occurring as the weights

Impairment of Financial Assets Incurred loss model vs expected loss model Incurred and expected loss model report credit losses from different perspectives. Incurred Loss Model Allocates credit loss to the period when that loss is incurred. Revenue is recognised in full without considering expected credit losses Credit losses are recognised separately as impairment charges when are incurred. Thus higher revenues recognised in the period immediately after initial recognition, followed by lower net income if credit losses are incurred. Expected Loss Model Allocates the initially expected credit loss to the periods when revenue is recognised Revenue is reduced to reflect expected future credit losses at inception. If credit losses occur as expected, net income will be low in early periods and higher towards the end of the financial asset‘s life after losses have been incurred

EC Loss Provision: Example Orange bank advanced a 3 year interest bearing loan of MU 2,000,000 to a customer on 1 July 20x4. Estimated risk of default in next 12 months was 2% and 5.5% for the remaining term. The loss from default is estimated as MU 800,000. Orange bank has a reporting date of 31st Dec. By 31 Dec 20x4, estimated 12 months risk of default at 3.5% and in the remaining term 10.5%. The loss estimated from default was MU 750,000. On 31 Dec 20x5 estimated 12 months risk of default was 1.5% and 1% for remaining term. Estimated loss was MU 450000

EC Loss Provision: Example Initial recognition: 1 July 20x4 Credit loss provision will be MU 16000 computed as 2% of MU 800,000 Subsequent measurement: 31 Dec 20x4 The overall credit risk increased from 7.5% to 14% - a significant deterioration Credit loss provision will be MU 105,000 computed as [750,000 x (3.5% + 10.5%)] Subsequent measurement: 31 Dec 20x5 Credit loss provision will be MU USD 6750 computed as 1.5% of MU 450,000

Impairment Issues In order to operationalise this approach to impairment following three critical issues are to be decided upon: Definition of significant deterioration in credit quality Identification of point in time when credit quality deteriorated The future expected cash flow from impaired asset

Expected Credit Loss Model The expected credit loss model applies to Financial assets measured at amortised costs Financial assets mandatorily measured as FVTOCI Loan commitments when there is a present obligation to extend credit except when these are measured at FVTPL Financial guarantee, contracts to which IndAS 109 applies except those measured through FVTPL Lease receivables Contract assets

ECL Model: Basic Principles The general pattern of deterioration or improvement of credit quality should be reflected in the financial statements. Entities are required to base their measurement of expected credit losses on reasonable and supportable information available without undue cost or effort Historical, current, and forecast information may be used for the measurement Expected credit losses are updated at each reporting date for new information and changes in expectations even if there has not been any significant increase in credit risk

ECL Model: Recognition Initial recognition: The entity must create a credit loss allowance or provision equal to 12 months expected credit losses This is calculated by multiplying the PD occurring in next 12 months by the total lifetime expected credit losses that would result from the default Subsequent measurement: If the credit risk increases significantly since initial recognition, this amount will be replaced by lifetime expected credit losses If the credit quality subsequently improves and the lifetime expected credit losses criterion is no longer met, the 12 expected credit loss base is reinstated.

Expected Credit Loss Credit losses are the present value of all cash shortfalls while expected credit losses is an estimate of credit losses over the life of financial instruments. An entity should consider the following while measuring expected credit losses Probability weighted outcome Time value of money Reasonable and supportable information The three stage expected credit loss model also applies to the undrawn portion of overdraft, credit card, and other approved but undrawn facilities

Simplified Approach: Loans and Receivables For trade receivables without an IndAS115 (Revenue from contracts) financing element, the loss allowance will be measured at lifetime expected credit losses at initial recognition. For other trade receivables and lease receivables, the reporting entity can choose a separate accounting policy to apply the 3 stage approach or recognise an allowance for lifetime expected credit losses from initial recognition

Simplified Approach: Illustration On June 1, 20x4 Fresco sold goods on credit to Buy Co for MU 200,000. Buy Co has a credit terms of 60 days. Fresco uses the following matrix Buy Co had not paid by July 31, 20x4 Fresco learnt of financial difficulties at Buy Co Buy Co has confirmed that they will make payment Days Overdue Expected Loss Provision Nil 1% 1-30 5% 31-60 15% 61-90 20% 90+ 25%

Simplified Approach: Illustration 20x4 Debit Credit June 1 Trade receivable 200000 Revenue Expected Credit Losses 2000 Allowance for Receivables July 31 8000