Derivatives Accounting – Part I

Ind AS 109 requires derivatives to be classified as ‘fair value through profit or loss’ (FVTPL).  This means that all the derivatives should be valued at fair value at every reporting period and the fair value changes should be recognised in the profit and loss account.  The fair value of the derivative itself should be recognised in the balance sheet.  If the derivative has a positive fair value, then it should be shown as an asset and if it has a negative fair value, then the same should be shown as a liability.

Ind AS 32 recognises derivative when the standard defines a financial asset and a financial liability.  A derivative which should be shown as an asset is specified in the accounting standard Ind AS 32 as a contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity. Similarly a derivative which should be shown as a liability is specified in the accounting standard Ind AS 32 as a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.

Derivative financial instruments create rights and obligations that have the effect of transferring between the parties to the instrument one or more of the financial risks inherent in an underlying primary financial instrument.

On inception, derivative financial instruments give one party a contractual right to exchange financial assets or financial liabilities with another party under conditions that are potentially favourable, or a contractual obligation to exchange financial assets or financial liabilities with another party under conditions that are potentially unfavourable. However, they generally do not result in a transfer of the underlying primary financial instrument on inception of the contract, nor does such a transfer necessarily take place on maturity of the contract. Some instruments embody both a right and an obligation to make an exchange. Because the terms of the exchange are determined on inception of the derivative instrument, as prices in financial markets change those terms may become either favourable or unfavourable.

A put or call option to exchange financial assets or financial liabilities gives the holder a right to obtain potential future economic benefits associated with changes in the fair value of the financial instrument underlying the contract. Conversely, the writer of an option assumes an obligation to forgo potential future economic benefits or bear potential losses of economic benefits associated with changes in the fair value of the underlying financial instrument.

The contractual right of the holder and obligation of the writer meet the definition of a financial asset and a financial liability, respectively. The financial instrument underlying an option contract may be any financial asset, including shares in other entities and interest bearing instruments. An option may require the writer to issue a debt instrument, rather than transfer a financial asset, but the instrument underlying the option would constitute a financial asset of the holder if the option were exercised. The option-holder’s right to exchange the financial asset under potentially favourable conditions and the writer’s obligation to exchange the financial asset under potentially unfavourable conditions are distinct from the underlying financial asset to be exchanged upon exercise of the option. The nature of the holder’s right and of the writer’s obligation are not affected by the likelihood that the option will be exercised.

Further details on derivatives accounting will be covered in Derivatives Accounting – Part 2.

Training course on Financial Instruments – Ind AS 109

Three day training course on Financial Instruments as per Ind AS requirements

Day 1

Session

Topics covered

Session 1
10 am to 1 pm
Basic concepts of derivative instruments
  – What are derivatives and why we need them

  – Meaning of Forward, Futures and options
  – Pricing futures
  – Hedging, speculation & gambling
  – Option basics: ITM, ATM, OTM, Exercise, Lapse
Session 2
2 pm to 5 pm
Advanced concepts on derivative instruments
  – Greeks in options pricing
  – Black-Scholes model / Binomial model   
  – Put-call parity
Features of equity and equity derivatives
– Exercise with practical problems

Features of Interest Rate Derivatives
  – Interest Rate Swaps
  – Interest Rate CAPs / Floors
  – Interest Rate Collars / Reverse Collars
  – Cross Currency Swaps
Fixed Income Securities
FX Derivatives
Credit Default Swaps
Total Return Swaps

Day 2

Session

Topics covered

Session 1
10 am to 1 pm
Accounting Standard Ind AS 32
  – Financial asset and financial liabilities
  – Compound instruments
  – Liability Vs. Equity
Session 2
2 pm to 5 pm
Accounting Standard  Ind AS 109
  – Recognition, measurement, subsequent measurement

  – Amortized cost
  – Classification, reclassification & derecognition
  – Impairment
  – Embedded derivatives
Ind AS 107 Disclosures
 – Live examples from published accounts

Report of the working group on implementation of Ind AS by Banks
 – Discussion of the report and practical implications thereof

Day 3

Session

Topics covered

Session 1
10 am to 11.15 pm
Accounting for financial instruments
  – Interest rate derivatives
  – Fixed income securities
Effect of changes in foreign exchange rates Ind AS 21
  – Impact on financial instruments / hedge accounting
Session 2
11.30 am to 1 pm
Hedge Accounting
  – Fair Value Hedge

  – Cash Flow Hedge
Session 2
2 pm to 5 pm
Hedge Accounting
  – Case studies on Hedge Accounting

Financial instruments nuances in First time adoption

For details please send email to rvsbell@gmail.com or contact +919444025255

Financial Liabilities – Fair Value Option

Credit umbrella

Financial liabilities that are non-derivatives are normally valued at amortised cost.  Effective interest rate is computed for financial liabilities and based on that the interest expense is recognised on a periodical basis.  Transaction costs to source the liability are reduced from the financial liability for the purpose of calculating the effective interest rate.

An entity can, however, value a financial liability at fair value provided it eliminates or significantly reduces an accounting mismatch.  When an entity avails this option, then the financial liability is valued at fair value.  The difference between the carrying value and the fair value is recognised in the profit and loss account.

Let us assume that an entity issues a debt instrument for Rs.100 crores.  Let us also assume that the debt carries an interest rate of 8% per annum.  The debt being a non-derivative financial liability should be categorised as amortised cost liability and valued at amortised cost at every reporting period.  Let us also assume that at the time of issue, the bench mark interest rate was 6% and the credit risk premium amounts to 2% based on the credit rating of the entity.

If the entity exercises the option to classify the financial liability by availing the ‘Fair Value Option’ (FVO) option, then the liability will be valued at fair value on every valuation date.  If the liability is to be valued on a fair value basis, then it is necessary to find out the appropriate rate at which the liability and associated cash flows should be discounted to arrive at the fair value.  Let us assume that the bench mark interest rate becomes 7% at the end of the year and the credit rating remains the same.  The financial liability will be valued based on 9% (7% towards bench mark interest plus 2% towards credit risk premium) to arrive at the fair value of the liability.  Let us assume that the fair value of the liability at the end of the year based on 9% is Rs.97 crores.  This means that the carrying value of the liability would be written down from Rs. 100 crores to Rs. 97 crores resulting in a profit of Rs. 3 crores.  The entity will pass the following entry to record the fair value of the financial liability:

Date Particulars Debit (₹) Credit (₹)
8% Debt Instrument (Financial liability) A/c 3,00,00,000
   To Fair Value changes in Financial Liability (P&L) A/c 3,00,00,000
(Being the fair value of the financial liability of Rs.97 crores recorded by transferring the difference between the carrying value and the fair value amounting to Rs.3 crores to the P&L account)

 

Increase in Credit Risk

Let us assume that the bench mark interest rate remains the same viz., 6% at the end of the year.  The entity incurs losses in the next 4 quarters and is perceived by the market as a risky enterprise. The credit rating of the entity goes down and the credit risk premium increases from 2% to 4%.  Now the financial liability will be discounted at 10% (6% towards bench mark interest rate plus 4% towards credit risk premium).  Let us assume discounting the cash flows based on 10% results of the financial liability being valued at Rs. 95 crores.  The entity will then record a further profit of Rs.2 crores towards the fair value changes of the financial liability. The entity will pass the following entry:

Date Particulars Debit (₹) Credit (₹)
8% Debt Instrument (Financial liability) A/c 2,00,00,000
   To Fair Value changes in Financial Liability (P&L) A/c 2,00,00,000
(Being the fair value of the financial liability of Rs.95 crores recorded by transferring the difference between the carrying value and the fair value amounting to Rs.3 crores to the P&L account)

 

Here the entity earns a profit of Rs.5 crores without having to do anything.  In fact, the entity is now worse off than it was at the beginning of the year since the credit rating has gone down.  In spite of this, the entity makes a profit of Rs.5 crores.  This looks a bit weird and is counterintuitive, as this ipso facto means that the entity becomes more profitable if it becomes more risky.  The accounting standard has duly recognised this anomaly and has appropriately plugged the loop hole.  Now as per Ind AS 109, the fair value changes on account of credit risk is recognised in the other comprehensive income (OCI) while the fair value changes on account of changes in the bench mark interest rate is recognised in the profit and loss account.

Classification of financial assets

As per Ind AS 109, financial assets should be classified as one of the following:

  1. Amortised cost
  2. Fair value through other comprehensive income or
  3. Fair value through profit or loss

Classification is based on the analysis of the following two key factors:

  1. The entity’s business model for managing the financial assets and
  2. Contractual cash flow characteristics of the financial assets.

For an instrument that does not have a defined maturity period, the financial asset should be classified as either fair value through profit or loss or fair value through other comprehensive income.

For a debt security (since it has a pre-defined maturity period), all the three types of classification as mentioned above is possible viz., Amortised cost, Fair value through other comprehensive income or Fair value through profit or loss.
Key criteria to be examined for the purpose of classification of financial assets:

1) The entity’s business model: The business model of the entity should be analysed to find out if the financial asset is held with the objective to collect contractual cash flows that are solely payment of principal and interest or to collect such contractual cash flows as well as to buy or sell such financial asset. The business model objective should be analysed at the portfolio or sub-portfolio level and not on instrument-by- instrument basis. Such analysis should not be conducted at the entity level either, as the entity may have multiple business models to achieve different objectives for different sets of portfolios.

2) SPPI Criterion: The next key test to be performed is the test to find out if the contractual cash flows represent solely payment of principal and interest only. To understand the significance of this test, one need to have a very thorough knowledge of what is meant by both principal as well as interest. The standard specifies that principal is the fair value of the financial asset on initial recognition. Interest is primarily a consideration for the time value of money and includes the consideration for the credit risk associated with the financial asset. Interest also includes consideration for the other basic lending risks and costs including the profit margin.

If the financial asset is held with the business model objective to collect contractual cash flows that represent solely payment of principal and interest, then such a financial asset should be measured at amortised cost.

If the business model objective is to collect both the contractual cash flows as well as to buy and sell such financial assets, the financial asset should be classified as fair value through other comprehensive income, provided the contractual cash flows represent solely payment of principal and interest.

If the contractual cash flows do not represent solely payment of principal or interest or if the financial asset is held with the business model objective, i.e. neither to collect the contractual cash flows nor to buy or sell such financial assets, then the classification should be fair value through profit and loss account.

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