FINANCIAL INSTRUMENTS IFRS 7 IAS 32 IAS 39 by Dr.Anjali Bhave

Financial instruments background Increased complexity of financial instruments Harmonised global markets Concept of fair value

Financial instruments background Need for better disclosures and assessment of risks Unprecedented global financial crisis Governance issues

What is included in the standards? IAS 39 Recognition and derecognition of financial instruments Measurement of financial instruments Derivatives and hedge accounting

What is included in the standards? IAS 32 Presentation of financial instruments - Debt and Equity classification IFRS 7 Financial instruments disclosures

What is a Financial instrument? Contract giving rise to Financial asset of one entity and Financial liability / equity of another entity

Financial asset Any asset that is (a) Cash; (b) An equity instrument of another entity; (c) A contractual right to receive cash or another financial asset from another entity or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity or

Financial asset (d) A contract that may or will be settled in the entity’s own equity instrument and is 1) a derivative which will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments 2) non derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or

Financial liability Any liability that is a) A contractual obligation 1) to deliver cash or another financial asset to another entity or 2) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity

Financial liability b) A contract that will or may be settled in the entity’s own equity instruments 1) a derivative which will or may be settled other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments 1) non derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or

Examples Financial assets Financial liabilities Cash Investment in shares Receivables Loans to other entities Investments in bonds and other debt instruments Financial liabilities Trade payables Loans from other entities Bonds and other debt instruments issued

Categories of Financial assets – IAS 39 Financial assets held for trading Held-to-maturity investments Loans and receivables Available-for-sale financial assets

Categories of Financial assets – IAS 39 Financial assets at fair value through profit or loss Designated as such upon initial recognition Those classified as held for trading Derivatives not accounted for as hedges

Classification as held for trading Acquired or incurred principally for the purpose of selling or repurchasing it in the near term Part of a portfolio of identified financial instruments with evidence of a recent actual pattern of short-term profit-taking

Classification as held for trading A non hedging derivative An entity may also designate an entire hybrid contract at fair value through profit or loss if the contract contains one or more embedded derivatives

Categories of Financial assets – IAS 39 Held-to-maturity investments - financial assets With fixed or determinable payments and fixed maturity (eg, debt securities and redeemable preference shares) That an entity has the positive intent and ability to hold to maturity.

Categories of Financial assets – IAS 39 Loans and receivables Non-derivative financial assets with fixed or determinable payments not quoted in an active market Arise when entity provides money, goods or services directly to a debtor with no intention of trading the receivables .

Categories of Financial assets – IAS 39 Available-for-sale financial assets Residual category – assets that are not classified in another category

FINANCIAL INSTRUMENTS – DECISION TREE FOR CATEGORIES Asset is acquired/held to generate profit? Or originated to be sold in the short-term? YES NO Part of portfolio with a pattern of profit taking? YES NO Is it a derivative? Is its designated & effective hedge YES NO NO YES Are there: -fixed and determinable payments -fixed maturity - intent & ability to hold maturity? Apply hedge accounting NO Is there intention to sell in the short term? Is it created by giving money, goods or services directly to debtor? YES YES NO NO YES Financial assets at fair value through P&L Loans and receivables Available for sale Held to maturity

Categories of financial liabilities – IAS 39 Financial liabilities at fair value through profit or loss designated as such upon initial recognition and classified as held for trading Derivatives unless accounted for as hedges

Categories of financial liabilities – IAS 39 Financial liabilities measured at amortised cost Residual category – Liabilities that are not classified in another category

Derivatives Financial instruments with following characteristics: Value changes in response to changes in an ‘underlying’ price or index Requires no initial net investment or an initial net investment that is smaller than would be required to purchase the underlying instrument Settled at a future date.

Recognition and Initial measurement All financial assets and liabilities need to be recognised At fair value When the entity becomes party to the contractual provisions of the instrument

Fair value Amount for which an asset could be exchanged or liability settled Between knowledgeable willing parties In an arm’s length transaction

Example of fair value of a debt instrument classified as HTM Loan given to a vendor Rs 10000 For a period of 5 years, Carries interest at a rate of 5% (payable annually) Interest rate for similar loans from the market is 10%. The loan’s fair value is calculated as a net present value of interest payments and principal repayments discounted at 10% is 8,105

Subsequent measurement INSTRUMENT Financial assets at fair value through profit or loss MEASUREMENT Fair Value VALUE CHANGES P&L

Subsequent measurement INSTRUMENT Held-to-maturity investments MEASUREMENTA mAmortised cost effective interest ratertised cost (effective interest rate) VALUE CHANGES Not relevant (unless impaired)

Subsequent measurement INSTRUMENT Loans and receivables MEASUREMENTA mAmortised cost (effective interest rate)rtised cost (effective interest rate) VALUE CHANGES Not relevant (unless impaired)

Subsequent measurement INSTRUMENT Available-for-sale MEASUREMENTA cFair Valuest (effective interest rate) VALUE CHANGES Equity

IAS 32 DEBT EQUITY CLASSIFICATION Classification - substance of a financial instrument rather than its legal form Debt - Contractual obligation to deliver cash or another financial asset under conditions that are potentially unfavourable Equity - Exposure to the risk of fluctuations in price or residual interest of issuer’s equity

FINANCIAL INSTRUMENTS – DEBT EQUITY CLASSIFICATION Yes No Is settlement in cash either: -mandatory -at the option of the holder Does the settlement depend on the outcome of uncertain future events or circumstances beyond the issuing undertaking’s control? In substance, does the issuing undertaking have full discretion to avoid cash settlement? Is the possibility that the issuing undertaking will be required to settle in cash/other financial asset remote? Is settlement in a variable number of the issuing undertaking’s equity securities? Is the holder exposed to the risk of fluctuations in (a)price or (b)(b)residual price or (b) residual interest in the issuing undertaking's own equity securities? EQUITY LIABILITY :

IAS 32 DEBT EQUITY CLASSIFICATION A financial instrument is a liability if it is a contractual obligation to deliver cash or other financial assets - equity if it evidences a residual interest in the assets of an undertaking after deducting all of its liabilities.

IAS 32 DEBT EQUITY CLASSIFICATION Convertible debt that gives the holder choice of repayment in cash or in shares -- separated into its debt and equity components. Analysed into an issue of ordinary debt at a discount, and a credit to equity for the conversion right.

IAS 32 DEBT EQUITY CLASSIFICATION A convertible bond issued @ Rs 100 carrying 6% interest p.a, Convertible in 25 equity shares after 3 years Bond without convertible feature carry interest @ 9%. Value of debt = PV of interest payments + PV of principal @ 9% = 5.5+5.05+4.63+77.22 =92.4 Value of equity = 100- 92.4 = 7.6

IAS 32 Convertible instruments Fixed for fixed principle Contract to exchange a financial asset for an entity’s own equity instruments is classified as equity only if the amount of financial assets And the number of equity instruments are fixed.

IAS 32 FCCB If the amount is fixed but in a currency other than the functional currency of the issuing entity, then the amount is not fixed for the purpose of classifying the financial instrument FCCBs to be accounted for as liability at fair value through profit and loss.

Reclassification Trading Not permitted Loans and receivables Trading - If pattern of short term profit making Held-to-maturity Trading / Available for sale - Tainting

Reclassification Available for sale Trading - If pattern of short term profit making Held to Maturity Change in intent and if all criteria met

Amortisation Calculated using the effective interest rate method = the rate that exactly discounts estimated future cash flows through the expected life of the financial instrument IRR

Amortisation To continue the previous example Value of debt = 92.4 Cost of issue 1% Net proceeds 92.4-.92 = 91.48 The rate that equates this inflow with outflows of 6,6,106 is 9.38% This rate is called effective interest rate and used for amortisation

Amortisation Opening balance Interest @9.38% Cash paid Closing liability 91.48 8.58 6 9.48 94.06 8.82 96.88 9.09 99.97 / 100

Derecognition Derecognition is removal of an asset or liability from the balance sheet The standard combines the ‘risk and rewards approach’ and ‘control approach

Derecognition A financial liability is removed from the balance sheet only when it is extinguished –that is when the obligation specified in the contract is discharged or cancelled, or expires A transaction is accounted for as a collateralised borrowing if the transfer does not satisfy the conditions for derecognition

Derecognition When The rights to the cash flows from the asset expire The rights to the cash flows from the asset and substantially all risks and rewards of ownership of the asset are transferred

Derecognition An obligation to transfer the cash flows from the asset is assumed and substantially all risks and rewards are transferred Substantially all the risks and rewards are neither transferred nor retained but control of the asset is transferred.

Derecognition If the undertaking retains control of the asset but does not retain or transfer substantially all the risks and rewards The asset is recognised to the extent of the undertaking’s continuing involvement.

Derecognition If an undertaking has neither transferred nor retained substantially all the risks and rewards of ownership of the transferred asset Then It assesses whether it has retained control over the transferred asset.

Derecognition If the undertaking has retained control It continues to recognise the transferred asset to the extent of its continuing involvement in the transferred asset If it has not retained control it derecognises the transferred asset.

Derecognition SPEs etc Many derecognition structures use undertakings (trusts, partnerships, etc.) that have been specifically set up for the acquisition of the transferred assets. The transfer of assets may qualify as a legal sale If the transferor controls the transferee, the transferor needs to consolidate the transferee.

Derecognition sequence Consolidate all subsidiaries (including all SPEs) Derecognition provisions are applied on a consolidated level Consider the subject of the derecognition provisions (financial asset, group of similar financial assets or a portion of a financial instruments or a group of similar financial instruments) Apply derecognition rules

DECISION TREE FOR DERECOGNITION OF ASSETS

Derecognition Financial liability (or part thereof) is removed from the balance sheet when it is extinguished when the obligation is discharged or cancelled or expires

IFRS 7 Disclosures Qualitative description Quantitative data Level of information Overburdening vis a vis obscuring due to aggregation

IFRS 7 Disclosures Objectives Information about FAs & their impact on financial performance Assessment of risk and how it is managed

IFRS 7 Disclosures Disclosures relate to the following risks Credit risk Liquidity risk and Market risk

IFRS 7 Disclosures The disclosures shall be either In the financial statements or Incorporated by cross-reference from the financial statements to some other statement, such as a management commentary or risk report Available to users on the same terms as the financial statements and at the same time.

Qualitative disclosures For each type of risk, an undertaking shall disclose (i) the exposures to risk and how they arise (ii) its objectives, policies and processes for managing the risk and the methods used to measure the risk and any changes in (i) or (ii) from the previous period

Qualitative disclosures Credit quality disclosures about the credit quality of financial assets that are neither past due nor impaired For ex - the amounts of credit exposures for each external credit grade - the rating agencies used; - the amount of an entity’s rated and unrated credit exposures

Qualitative disclosures Market risks Open positions in interest rate, currency and equity products, all of which are exposed to general and specific market movements.

Quantitative disclosures For each type of risk, an undertaking shall disclose Summary quantitative data about its exposure to that risk at the reporting date. Based on the information provided to key management, such as the board of directors or chief executive officer.

Disclosure of concentrations of risk From financial instruments that have Similar characteristics and Affected similarly by changes in economic or other conditions. Requires judgement reflecting the circumstances of the undertaking.

Disclosure of concentrations of risk Includes how management determines concentrations; the shared characteristic that identifies each concentration (eg counterparty, geographical area, currency or market) the amount of the risk exposure associated with all financial instruments sharing that characteristic

Disclosure of concentrations of risk Concentrations of assets, liabilities and off-balance sheet items Geographical Currency Industry Market Type of counterparty

Credit risk - disclosures Failure to pay by a counterparty causing financial loss Maximum credit exposure for each class of FI. Collateral and other credit enhancements obtained

Credit risk - disclosures The amount that best represents its maximum exposure to credit risk at the reporting date, without deducting any collateral held or other credit enhancements (such as netting agreements that do not qualify for offset – see IAS 32) In respect of the amount disclosed in (i), a description of collateral held as security and other credit enhancements;

Credit risk - disclosures Information about the credit quality of financial assets that are neither past due nor impaired and The carrying amount of financial assets that would otherwise be past due or impaired whose terms have been renegotiated

Credit risk - disclosures Past due / impaired Age analysis Analysis of asset Description and Fair value of collateral

Liquidity risk An undertaking shall disclose (i) a maturity analysis for financial liabilities (owed by the undertaking) that shows the remaining contractual maturities and (ii) a description of how it manages the liquidity risk inherent in (i).

Market risk Sensitivity analysis A sensitivity analysis is needed for each type of market risk to which the entity is exposed. A sensitivity analysis is disclosed for each currency to which an undertaking has material exposure.

Sensitivity analysis Not to include worst case or stress test situations Methods like VaR ( A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities)

IFRS 7 Usefulness? Voluminous Subjectivity Lack of comparability

THANK YOU Dr.Anjali Bhave arbhave@gmail.com 9322249029