Financial Instruments Practical Insights

Components of financial statements – IAS 1 Statement of financial position Statement of comprehensive income Most financial assets measured at fair value Complete set of Financial statements (effective 01 January 2009) Statement of changes in equity Statement of cash flows Notes including accounting policies

Statement of Comprehensive Income Items recognised in equity Most financial assets measured at fair value Items recognised in Profit and loss +

Items of income and expense recognised in Equity Effects of cash flow hedges Immediate recognition of Actuarial gains/losses Most financial assets measured at fair value Effect of translation of foreign operations Re measurement of AFS Revaluation of PPE and Intangibles

Market trends as reflected in IAS 32 and 39 Key principles of the Standard Harmonisation of markets Increased complexity All derivatives are recognised on the balance sheet Most financial assets measured at fair value Detailed disclosures Use of fair values Measurement of the hedging instrument is the basis for hedge accounting Reduction of options

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Scope exclusions - Extract IAS 32 IAS 39 IFRS 7 Applicable Standard Interests in subsidiaries X IAS 27 Interests in associates IAS 28 Interests in joint ventures IAS 31 Employers' right and obligations under employee benefit plans IAS 19 Financial instruments, contracts and obligations under share-based payment transactions IFRS 2 Rights and obligations under insurance contracts (except embedded derivatives and certain financial guarantees) IFRS 4 Rights and obligations under leases - IAS 17 Contracts for contingent considerations in a business combination (for the acquirer) IFRS 3 Loan commitment that cannot be settled net in cash or another financial instrument IAS 37

Scope inclusion - Commodity contracts IAS 39 applies to contracts to buy or sell a non-financial item that can be settled net in cash (…) unless the contract was entered into (and continues to be held) for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements

Definition of financial instruments A financial instrument is a contract that gives rise to: a financial asset of one entity and a financial liability or equity instrument of another entity Financial asset Financial liability Equity instrument Cash Equity instrument of another entity Contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions Certain contracts settled in the entity’s own equity Contractual obligation to deliver cash or another financial asset or to ex-change financial asset or liabilities under potentially unfavourable conditions Certain contracts settled in the entity’s own equity Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities

Examples of Financial Assets and Liabilities Equity Share Capital 8% Preference Share Capital Non Convertible debentures Convertible bonds paying 5% interest which converts into fixed number of shares Convertible bonds paying 5% interest which converts into shares to the value of the liability Share warrants to subscribe for a fixed number of shares for a fixed amount Derivatives-swaps, options,futures,forwards

Examples of Financial Assets and Liabilities (contd.) Plant Property & Equipment Investments Inventories Sundry Debtors Prepaid expenses Security deposits Loans and advances Fixed deposits Finance leases Operating leases Income Tax Assets/Liabilities

Categories of financial instruments A financial asset or financial liability at fair value through profit or loss Held-to-maturity investments Loans and receivables Available-for-sale financial assets

Categories of financial assets Category Definition Financial assets at fair value through profit or loss Financial assets held for trading Derivatives, unless accounted for as hedges Financial asset designated to this category under the fair value option Loans and receivables Non-derivative financial assets with fixed or determinable payments that are not quoted in an active market Held-to-maturity investments Non-derivative financial assets with fixed or determinable payments and fixed maturity that the entity has the positive intent and ability to hold to maturity Available-for-sale financial assets All financial assets that are not classified in another category are classified as available-for-sale Any financial asset designated to this category on initial recognition

Categories of financial liabilities Category Definition Financial liabilities at fair value through profit or loss Financial liabilities held for trading Financial liability designated as at fair value through profit or loss on initial recognition (fair value option) Other financial liabilities – at amortised cost All financial liabilities that are not classified at fair value through profit or loss

Categories of financial assets/liabilities-Examples Financial assets/liabilities principally for the purpose of selling or repurchasing in near term. Venture capital organization/mutual fund that invests in financial assets with the object of profiting from their total return in form of interest, dividend and changes in fair value. Fixed maturity debts that bears interest at a fixed or variable rate Derivatives with negative fair value

Fair value option Designation of financial instruments as at fair value through profit or loss is permitted, when The designation eliminates or significantly reduces “accounting mismatches” A group of financial assets and/or liabilities is managed on a fair value basis An embedded derivative that meets particular conditions Only available at initial recognition Designation is irrevocable No requirement for consistency, meaning that an entity can choose which, if any, of its financial instruments are to be designated

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Definition - Derivative Three characteristics Fair value changes in response to the change in underlying Interest rate, Security price, Commodity price, Foreign exchange rate, Credit rating, or Other index No or little initial net investment Settled at a future date

Examples of derivatives and underlyings Type of contract Main pricing-settlement variable (underlying variable) Interest rate swap Currency futures Commodity forward Credit swap Purchased or written stock option (call or put) Interest rate Currency rates Commodity prices Credit ranking, credit index or credit price Equity prices (equity of another entity)

Embedded derivatives - Identification What are they? / How to identify? An implicit or explicit term in a contract that makes it behave like a derivative Instruments with conversion features Index linked payments Transactions in “third currency” Instruments with option to extend the term of debt

Embedded derivatives - Separation When to separate? The economic characteristics and risks of the embedded derivative are not closely related to economic characteristics and risks of the host contract, and A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, and The hybrid contract is not carried at fair value through profit or loss (i.e. a derivative imbedded in a financial asset or financial liability measured at fair value through profit or loss is not separated

Embedded derivatives - Accounting Accounting following separation: Apply rules of IAS 32/39 (or other applicable IAS if host is not a financial instrument) to the host contract Measure the separated derivative at fair value through P&L Accounting when separation is difficult: If it is difficult to separate the embedded derivative, may choose to fair value through profit or loss for the entire combined contract. However, the host contract must be a financial instrument Accounting when impossible to separate: If the embedded derivative cannot be reliably identified and measured, the entire combined contract is accounted for as a financial instrument at fair value

Embedded derivatives – Example Australian company leases an aircraft from a UK company for 2 years. Monthly rentals of Euro 20,000 are payable at the beginning of each month. What is the host contract? Are there any derivatives embedded in it? Do the derivatives need to be separated?

Embedded derivatives – Example (solution) What is the host contract? Lease contract (not carried at fair value) Are there any derivatives embedded in it? Yes, there are implied forward contracts to exchange Euro (which are within the scope of IAS 39) Do the derivatives need to be separated in year 1? Yes, there are 23 embedded forward contracts to exchange Euro 20,000 for Australian dollars (each of these embedded forward contracts is a derivative that is within the scope of IAS 39 and the host contract is not carried at fair value.)

Embedded derivatives - Re-assessment Assessment of separation when entity first becomes party to a contract Re-assessment of embedded derivatives (IFRIC 9) Reassessment is prohibited unless there is a change in the terms of the contract that significantly modifies the cash flows First-time adopter assesses on the conditions when first becoming party to the contract Purchaser of hybrid contract assesses based on the conditions at that date

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Recognition All financial assets and financial liabilities, including derivatives, should be recognised on the balance sheet when the entity becomes party to the contractual provisions of the instrument Financial assets @ “fair value of consideration given” Financial liabilities @ “fair value of consideration received”

Initial measurement Measured at fair value on initial recognition Transaction costs are included in the initial measurement of financial instruments that are not measured at fair value through profit or loss. Applies to all financial instruments – whether or not negotiated on an arm’s length basis (e.g., interest-free loans by a shareholder or government)

Fair Value Concepts Fair value is defined as the amount for which an asset could be exchanged or a liability settled between knowlegeable and willing parties in an arm’s length transaction. Fair value does not take into consideration transaction costs expected to be incurred on transfer or disposal of a financial instrument. Fair value of a financial instrument on initial recognition is normally the transaction price( i.e. fair value of consideration given or consideration received)

Guidance on fair values Active market: unadjusted published price quotations No active market: valuation techniques using maximum market input and minimum entity specific input Fair values of equity instruments: in the absence of market quotation are to be based on estimates or cost less impairment (as a last resort and only if impossible to make reliable estimates)

Case study – Inter-company loans Fair value of below market loans- is the present value of the expected future cash flows using a market –related rate If the loan is from a shareholder acting in the capacity of a shareholder, then the resulting credit should be reflected in equity as contribution from shareholder- loans by parent to subsidiary Fair value of an interest free loan repayable on demand is not less than its face value and hence should not be discounted Long term interest free/low interest advances for purchases in nature of loans given should be discounted to its present value

Subsequent measurement of financial instruments Value changes Financial assets at fair value through profit or loss Fair value P&L Held-to-maturity investments Amortised cost (effective interest rate) Not relevant (unless impaired) Loans and receivables Amortised cost (effective interest rate) Not relevant (unless impaired) Available-for-sale Fair value Equity (unless impaired) Financial liabilities at fair value through profit or loss or designated as such Fair value P&L Other liabilities Amortised cost Not relevant Derivatives Fair value P&L

Amortised cost and effective interest method Initial recognition amount Principal repayments Accumulated interest Impairment reduction = - -/+ - Amortisation is calculated using the effective interest rate method At each reporting date apply the effective interest rate to carrying amount to determine interest income and interest expense

Case study- Measurement and disclosure of investments An entity receives $100m equity in cash on 1 July 2005. It invests in a bond of $100m par at a clean price of 97 with a 5% fixed coupon on 1 July 2005. Coupons are paid annually and the bond has a maturity date of 30 June 2007. The yield to maturity is calculated as 6.6513%. On 30 June 2006 the entity receives the first coupon payment of $5m. The clean market value of the security has increased to 99 at 30 June 2006. The security has not been impaired and no principal has been repaid. Using the effective interest method, the $3m discount is amortized 1.45 in year 1 and 1.55 in year 2.

Solution- Measurement and disclosure of investments

Case study-Subsequent measurement at ammortised cost Company A has obtained a loan of INR 2202.70 million as at 31 December 2006 repayable on 31 December 2013. Interest rate for the borrowing is 1.75 %( considered to be at market rate). In addition ,processing fee paid upfront aggregates INR 13.86 million.

Solution-Measurement of loans at ammortised cost Accounting adjustments would be required to state the loan at ammortised cost after considering the upfront fee / transaction cost payment made amounting to INR 13.86 million. Bank Loan will initially be recognized at fair value and interest will be accounted under effective interest rate method as denoted below: Sr. No. Date Interest (1.75%) Interest Amortization of Amortized costs (A) 1.846% (B) discount .(B)-(A) (Amt.in Rs.) 1 31 Dec 06 - - - 2,188,843,697 2 31 Dec 07 38,547,425 40,421,259 1,873,834 2,190,730,147 3 31 Dec 08 38,547,425 40,455,863 1,908,438 2,192,638,585 4 31 Dec 09 38,547,425 40,491,105 1,943,680 2,194,582,266 5 31 Dec 10 38,547,425 40,526,999 1,979,574 2,196,561,840 6 31 Dec 11 38,547,425 40,563,556 2,016,131 2,198,577,972 7 31 Dec 12 38,547,425 40,600,787 2,053,362 2,200,631,334 8 31 Dec 13 38,547,425 40,638,706 2,078,665 2,202,700,000 269,831,975 283,698,278 13,866,303

Reclassifications from held-to-maturity category Sales before maturity reclassify ALL instruments Change of intent or ability reclassify ALL instruments “Tainting” leads to measurement at fair value And classification as AFS assets for two years

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Impairment requirements A financial asset or a group of financial assets is impaired if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after initial recognition; and the loss event has an impact on estimated future cash flows An impairment loss is measured as the difference between: the asset’s carrying amount and the present value of estimated future cash flows - for loans and receivables or held-to-maturity investments; and the acquisition cost (net of any principal repayment and amortisation) and current fair value, less any impairment losses previously recognised– for available-for-sale financial assets

Loans and receivables - Objective evidence of impairment At each balance sheet date, the entity should assess whether there is objective evidence of impairment for an asset or group of financial assets Significant financial difficulty of the issuer/obligor Default or breach of contract Granting of a concession by the lender Bankruptcy or financial reorganisation of the borrower Disappearance of an active market for the assets concerned Measurable decrease in the estimated future cash flows

Loans and receivables - Impairment assessment Objective evidence of impairment of individually significant assets, and individually or collectively for assets that are not individually significant? Assess impairment Yes No Credit risk characteristics similar to portfolio of assets? Assess impairment collectively Yes No Continue to assess individually

Loans and receivables - Evaluation of impairment on a portfolio basis Future cash flows Estimated cash flows Historic loss experience Changes in related observable data Discount rate Original effective interest rate Losses incurred but not reported At each year end the present value of the estimated cash flows is re-calculated and impairment loss recognised for the difference between this amount and the carrying value of the portfolio. The estimated cash flows take into account incurred losses, not expected future losses When loans are identified as individually impaired they are removed from the portfolio

Loans and receivables - Measurement of incurred losses on a portfolio basis Historic loss rate Loss confirmation period Loan’s balance of portfolio = x x Incurred loss defines impairment loss Historic loss rate is determined using historical data adjusted for economic conditions existing at the balance sheet date Loss confirmation period (‘emergence period’) is the average lag between incurrence of loss and confirmation of loss dates Incurrence loss date is the date on which objective evidence of impairment occurs on an individual asset basis Confirmation loss date is the date on which objective evidence of impairment is identified on an individual asset basis

Impairment of available-for-sale equity securities Additional indicators of impairment for equity securities Adverse effects of changes in technological, market, economic or legal environment, in which the entity operates Significant or prolonged decline in the fair value of an investment in the equity instrument Equity instruments Impairment loss can not be reversed through profit or loss as long as the asset continues to be recognised

Impairment of available-for-sale debt securities Indicators of impairment for debt securities (similar to those for loans and receivables) Significant financial difficulty of the issuer Bankruptcy or financial reorganisation of the issuer Disappearance of an active market for the bonds concerned Measurable decrease in the estimated future cash flows Debt instruments Impairment loss can be reversed through profit or loss if the increase can be objectively related to an event occurring after the loss was recognised

Case study- Impairment Company B has $1 million of auto loans granted to individual borrowers outstanding at the end of the reporting period. Based on examination of past losses the Company determined that it has a loss rate of 2%, which has been derived through dividing annual credit losses by the average loan balance each year for the applicable historical period. The Company determines also that the deterioration in the financial condition of its auto loans granted to individual borrowers occurs, on average, six months before the individual loans are identified as impaired (loss confirmation period is 0.5).

Solution to case study-Impairment Given the facts, the Company’s allowance for credit losses incurred but not reported for a portfolio of auto loans granted to individual borrowers would approximate six months’ worth of allowances. Thus the Company should estimate the incurred but not yet confirmed credit losses in a pool by estimating the loss confirmation period, computing a historical loss rate, and then multiplying the historical loss rate times the loss confirmation period times the pool’s loan balance. The portfolio based component of Company B’s allowance for credit losses would be $1,000,000 x 2% x 0.5 = $10,000 The calculated figures represent an estimate of losses incurred on loans in the pool to borrowers whose financial condition has deteriorated sufficiently to impair their loans, even though the Company has not yet identified the deterioration.

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Derecognition of a financial asset First, consolidate all subsidiaries (including all SPEs) Derecognition provisions are applied on a consolidated level Then, 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) Then, apply derecognition rules: Derecognise when contractual rights to cash flows expire or There is a “transfer of a financial asset” and That transfer qualifies for derecognition

Derecognition of a financial asset (contd.) “Transfer of a financial asset” requires A transfer of the contractual rights to receive the Cash Flows; or Meeting the “pass-through requirements” in IAS 39.19 If financial asset has been transferred, then assess whether transfer qualifies for derecognition If substantially all risks and rewards are retained If substantially all risks and rewards are transferred If some but not substantially all risks and rewards have been transferred: Control -> Continuing involvement A very mixed model !

Derecognition of a financial liability Financial liability (or part thereof) is removed from the balance sheet when it is extinguished, i.e. when the obligation is discharged or cancelled or expires

Derecognition principles may have a big impact on… Securitisations Securities lending Repurchase agreements Partial transfers of assets/liabilities Transfers involving special purpose entities Derecognition coupled with a new asset or liability Derecognition rules are strict

Case study 1 -Derecognition Company A is a manufacturing entity that has several arrangements whereby it sells trade receivables to financial institutions for cash with no conditions attached. The Company favors these arrangements as it receives cash more quickly than waiting for customers to pay their outstanding in the normal 30 or 60 day terms. The customers are notified of the sale and pay directly to the bank. There is no recourse for the bank and Company A only guarantees the existence of the trade receivables, but not creditworthiness of the customers etc. Does the described transaction qualify for derecognition?

Solution –Case Study 1 Company A would de-recognise the transferred receivables

Case study 2 -Derecognition Company B sells 100 of short-term receivables to a Bank for cash by guaranteeing to buy back first 20% of defaulted receivables, while the historic default rates on such receivables are up to 5%. The customers are notified of the sale and pay directly to the bank. Does the described transaction qualify for derecognition?

Solution – Case study 2 Even though a financial asset has been transferred, receivables cannot be derecognised from Company B’s financial statements because it has retained substantially all risks and rewards of ownership.

Case study 3 -Derecognition Company C sells 100 of short-term receivables to a Bank for 98 and at the same time C guarantees to buy back first 5% of defaulted receivables. The credit losses on the portfolio of receivables range between 3% to 7% with a confidence interval of 99% and an expected loss of 5%. The fair value of the guarantee at the date of transaction is 4. The customers are notified of the sale and pay directly to the bank. According to the terms of the sale, the Bank cannot sell or pledge the purchased receivables. Does the described transaction qualify for derecognition?

Solution – Case study 3 The Company has neither transferred nor retained substantially all of the risks and rewards and retained control over the receivables. Consequently, the receivables cannot be derecognised from Company C’s financial statements to the extent of its continuing involvement in the transferred receivables.

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

ICAI Announcement-Accounting for derivatives The recent ICAI announcement (applicable to financial statements for the period ending March 31, 2008 or after) on accounting for derivatives lays down the following two alternatives, out of which a company must select one. (a) Follow Accounting Standard 30, Financial Instruments: Recognition and Measurement or (b) Provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market “keeping in view the principle of prudence as enunciated in AS 1.”

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

IFRS 7- Financial Instruments :Disclosures Overview Effective for annual periods beginning on or after 1 January 2007 (earlier application is encouraged) Supersedes IAS 30 and the disclosure requirements in IAS 32 (the classification requirements remained unchanged) Shall be applied by all entities to all risks arising from all financial instruments ( some exceptions apply) Applicable to recognised and unrecognised financial instruments within the scope of IFRS 7, even when outside the scope of IAS 39 (e.g., loan commitments)

Scope IFRS 7 to be applied by all entities and to all types of financial instruments except: Interest in subsidiaries, associates and joint ventures if accounted in accordance with IAS 27, IAS 28 or IAS 31 Employers’ rights and obligations from employee benefit plans under IAS 19 Insurance contracts as defined in IFRS 4 An acquirer’s interest in contracts for contingent consideration in a business combination Financial Instruments, contracts and obligations under IFRS 2

Key learning points IFRS 7 to be applied by all entities and to all types of financial instruments (some exceptions noted) Supersedes IAS 30 and the disclosure requirements in IAS 32 (the classification requirements remained unchanged) Standard allows entity to determine classes of financial instruments for certain disclosures Disclose information to evaluate significance of financial instruments for financial position and performance Qualitative disclosures - for each type of risk arising from financial instruments: The exposures and how they were generated Objectives, policies and processes for managing the risks and methods to measure the risk Any changes to the above from the previous period

Agenda Scope, definitions and categories Derivatives Recognition and measurement Impairment Derecognition ICAI Announcements –Derivatives IFRS 7 Summary

Definition of financial instruments A financial instrument is a contract that gives rise to: a financial asset of one entity and a financial liability or equity instrument of another entity Financial asset Financial liability Equity instrument Cash Equity instrument of another entity Contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions Certain contracts settled in the entity’s own equity Contractual obligation to deliver cash or another financial asset or to ex-change financial asset or liabilities under potentially unfavourable conditions Certain contracts settled in the entity’s own equity Contract evidencing a residual interest in the assets of an entity after deducting all of its liabilities

Subsequent measurement of financial instruments Value changes Financial assets at fair value through profit or loss Fair value P&L Held-to-maturity investments Amortised cost (effective interest rate) Not relevant (unless impaired) Loans and receivables Amortised cost (effective interest rate) Not relevant (unless impaired) Available-for-sale Fair value Equity (unless impaired) Financial liabilities at fair value through profit or loss or designated as such Fair value P&L Other liabilities Amortised cost Not relevant Derivatives Fair value P&L

Market trends as reflected in IAS 32 and 39 Key principles of the Standard Harmonisation of markets Increased complexity All derivatives are recognised on the balance sheet Most financial assets measured at fair value Detailed disclosures Use of fair values Measurement of the hedging instrument is the basis for hedge accounting Reduction of options