Contracts to deal with non-financial asset in foreign currency

Where an entity is in the practice of entering into a derivative contract to either buy or sell a non-financial item in foreign currency, such contracts will also not be regarded as financial instruments.  The entity should not be in the practice of dealing with such non-financial item merely with the intention to buy or sell in the short term with a view to making profits.

At the time of entering into contract to either buy or sell a non-financial item in foreign currency, there is also a foreign exchange component that is involved in such contracts.  The question arises as to whether the FX component should be segregated and treated as an embedded derivative to be valued on a fair value basis.

The answer is provided in the accounting standard whereby it clearly mentions that the embedded portions in such contracts need not be segregated.

An embedded foreign currency derivative in a host contract that is an insurance contract or not a financial instrument (such as a contract for the purchase or sale of a non-financial item where the price is denominated in a foreign currency) is closely related to the host contract provided it is not leveraged, does not contain an option feature, and requires payments denominated in one of the following currencies:

  1. the functional currency of any substantial party to that contract;
  2. the currency in which the price of the related good or service that is acquired or delivered is routinely denominated in commercial transactions around the world (such as the US dollar for crude oil transactions); or
  • a currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place (eg a relatively stable and liquid currency that is commonly used in local business transactions or external trade).

Hence, the forward contract dealing with a non-financial item in a foreign currency need not be fair valued.

Treatment of contracts dealing with non-financial assets

A contract to deal with a non-financial asset is not a financial instrument. Commodity contracts normally result in either taking delivery or giving delivery of a non-financial item. Such contracts are not regarded as a financial instrument as per financial instruments accounting standard viz., Ind AS 109.  However, if the contract is capable of being settled net in cash or any other financial asset, then such contract would be treated as though it is a financial instrument.

Exception to this principle

Contracts entered into with the sole purpose of either taking delivery or giving delivery of a non-financial item is not regarded as a financial instrument and is covered under the own-use exemption. However, there could be some derivative contracts dealing with non-financial items that may result in either delivery or providing delivery. If delivery or receipt of a non-financial item happens on account of a third party exercising an option (say put option), then the entity cannot claim exemption provided in ‘own-use exemption’. This happens especially when an entity enters into a written option contract to deal with a non-financial instrument. For example, if an entity writes a put option (sells a put option), then if the price of such non-financial asset drops below the put option strike price, then the buyer of such put option will exercise the option resulting in delivery of the non-financial item for the entity. In this case, even though the entity receives the non-financial item, it is not because of the entity’s choice to buy such a non-financial item but due to the third party exercising the put option resulting in delivery to the entity. Such contracts will be regarded as financial instruments and the entity should value such contracts on a mark to market basis.

If the entity avails ‘own-use exemption’ in respect of contracts that deal with non-financial items, such contracts need not be fair valued, as ultimately such contracts would result in either receipt or delivery of the non-financial item thereby directly impacting the cost of goods sold or consumed, as the case may be.

Foreword by Padma Shri T.N. Manoharan, Chairman, Canara Bank

T N ManoharanMr R. Venkata Subramani, known for his expertise in the field of Financial Instruments accounting, has come up with a new edition of his book on Accounting for Financial Instruments as per Ind AS, incorporating all the relevant aspects in various chapters. The book lucidly deals with the various dimensions of presentation, classification, recognition, measurement and derecognition of Financial instruments in the initial chapters which would empower any reader with a conceptual understanding of the subject matter. The Book further explains in a lucid manner the impairment methodology in addition to elucidating on embedded derivatives and its reclassification.

The book adequately deals with Hedge accounting both in terms of Fair value dimension as well as cash flow dimension. Comprehensive coverage on Fair value measurement of financial instruments and effects of changes in forex rates should be immensely useful to those who refer to this book. Guidance is also provided on first time adoption of the accounting standards for financial instruments. There is cross reference provided to the guidance note on accounting for derivatives. The guidance note on accounting for derivatives and extracts from annual reports incorporated in the last two chapters should serve as ready reference to the users of book.

Mr.R.Venkata Subramani is a Chartered Accountant having immense knowledge and expertise on the matters dealt with in this book. The benefit of his hands-on experience and in depth practical exposure is reflected in the illustrations given in the various chapters of this book. Accounting standards notified as IND AS are Indian version of the IFRS with appropriate modifications. All the business organizations are expected to comply with the IND AS within the timelines prescribed. Considering the complex nature of accounting for financial instruments and in the light of compliance requirement of new set of standards notified by the Government as IND AS, the significance of this book cannot be undermined.

Banks, financial institutions, Insurance companies, Investment bankers, dealers, brokers, professionals and other investors would find this book quite useful in the day-to-day operations, as various concepts unique to the financial instruments are explained besides laying down the accounting treatment in a detailed manner. This book will be a useful addition to any library, which serves as a source of knowledge and information to all those associated with financial instruments accounting.

Sri T.N. Manoharan
Chairman, Canara Bank
Padma Shri Awardee
Former President of ICAI

Message from CA. Tarun Jamnadas Ghia

CA Tarun GhiaMy compliments to CA. R. Venkata Subramani in bringing out the book ‘Financial Instruments as per Ind AS’ and making a very sincere attempt to bring out the nuances on financial instruments, relevant to Ind AS. The concepts have been explained in a lucid language with ample illustrations. Hedge accounting is another area explained in simplified manner with relevant examples. The writings on new impairment methodology should also be quite useful to the readers to understand the concept with more clarity. All the best.

Book cover


Valuation of financial guarantee contracts as per Ind AS 109 – valuation services

What is a financial guarantee contract?

A financial guarantee contract is a contract that requires the issuer to make specified payments to reimburse the holder for loss it incurs because a specified debtor fails to make payment that is due in accordance with the original or modified terms of a debt instrument.

Accounting for financial guarantee contracts

If an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting that is applicable to insurance contracts, the issuer may elect to apply either Ind AS 109 or Ind AS 104 to such financial guarantee contracts. The entity may make that election on a contract by contract basis. How-ever, the election for each contract is not revocable.

Financial guarantee contracts after initial recognition is measured at the higher of:

  1. Impairment loss allowance determined as per requirements of Ind AS 109 and
  2. The amount initially recognised less cumulative amount of income recognised as per Ind AS 18.

Date of initial recognition

For financial guarantee contracts, the date the entity becomes a party to the irrevocable com-mitment is considered to be the date of initial recognition for the purpose of applying the im-pairment requirements.

Legal form

A financial guarantee contract may have different legal forms viz., guarantee, letter of credit, a credit default contract or an insurance contract. The accounting treatment for such financial guarantee contract is not dependent on its legal form.
Contracts that are not financial guarantee contracts

Some credit-related guarantees do not, as a precondition for payment, require that the holder is exposed to, and has incurred a loss on, the failure of the debtor to make payments on the guaranteed asset when due. An example of such a guarantee is one that requires payments in response to changes in a specified credit rating or credit index. Such guarantees are not financial guarantee contracts as defined in this Standard, and are not insurance contracts as defined in Ind AS 104. Such guarantees are derivatives and the issuer should apply Ind AS 109 for such contracts.

If a financial guarantee contract was issued in connection with the sale of goods, the issuer should apply Ind AS 18 in determining when it recognises the revenue from the guarantee and from the sale of goods.
If a financial guarantee contract was issued to an unrelated party in a standalone arm’s length transaction, its fair value at the inception is likely to be equal to the premium received.

Timing of recognising life time expected credit losses

For financial guarantee contracts, an entity should consider the changes in the risk that the specified debtor will default on the contract. The significance of a change in the credit risk since initial recognition depends on the risk of a default occurring as at initial recognition. Thus, a given change, in absolute terms, in the risk of a default occurring will be more significant for a financial instrument with a lower initial risk of a default occurring compared to a financial instrument with a higher initial risk of a default occurring.

The risk of a default occurring on financial instruments that have comparable credit risk is higher the longer the expected life of the instrument; for example, the risk of a default occurring on an AAA-rated bond with an expected life of 10 years is higher than that on an AAA-rated bond with an expected life of five years.

For a financial guarantee contract, the entity is required to make payments only in the event of a default by the debtor in accordance with the terms of the instrument that is guaranteed. Accordingly, cash shortfalls are the expected payments to reimburse the holder for a credit loss that it incurs less any amounts that the entity expects to receive from the holder, the debtor or any other party. If the asset is fully guaranteed, the estimation of cash shortfalls for a financial guarantee contract would be consistent with the estimations of cash shortfalls for the asset subject to the guarantee.

Period over which to estimate expected credit losses

For financial guarantee contracts, this is the maximum contractual period over which an entity has a present contractual obligation to extend credit.

Time value of money

Expected credit losses on financial guarantee contracts for which the effective interest rate cannot be determined shall be discounted by applying a discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows but only if, and to the extent that, the risks are taken into account by adjusting the discount rate instead of adjusting the cash shortfalls being discounted.

Impairment on transition to Ind AS

On transition, an entity should seek to approximate the credit risk on initial recognition by considering all reasonable and supportable information that is available without undue cost or effort. An entity is not required to undertake an exhaustive search for information when determining, at the date of transition, whether there have been significant increases in credit risk since initial recognition. If an entity is unable to make this determination without undue cost or effort an entity shall recognise a loss allowance at an amount equal to lifetime expected credit losses at each reporting date until that financial instrument is derecognised.

In order to determine the loss allowance on financial guarantee contracts to which the entity became a party to the contract prior to the date of initial application, both on transition and until the derecognition of those items an entity shall consider information that is relevant in determining or approximating the credit risk at initial recognition. In order to determine or approximate the initial credit risk, an entity may consider internal and external information, including portfolio information.

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