Description About the Book
The book covers financial instruments from the perspective of the issuer as well as the investor. It explains the concept of recognition, classification and subsequent measurement of financial assets and liabilities, de-recognition of financial assets and liabilities and impairment model. It also covers fair value and cash flow hedge accounting, disclosures required for financial instruments, fair value concepts and effects of fluctuations in foreign exchange. It includes lucid commentary on Financial Instruments as per Ind AS, discussing Ind AS 32, Ind AS 109, Ind AS 107, and some portions of Ind AS 113 and Ind AS 21. As we all know, Financial Instruments accounting is a new concept in India. The Indian Accounting Standards relating to financial instruments are quite complex and voluminous. The said standards (along with other 34 standards) are applicable from 1st April 2016 for Phase 1 companies, while the rest of the world would be adopting the equivalent standard IFRS 9 only from 1st Jan 2018. This book includes the basics of financial instruments and also dwells deep into the Indian Accounting Standards mentioned above with several practical case studies along with solutions for the same. Key Features Discussion based on Ind AS 32, 109, 107, 113 & 21 Elucidating topics with practical case studies Includes lucid explanation on hedge Accounting A guide to the certificate course in Ind AS (ICAI) and Dip in IFRS (ACCA, UK).
IFRS 9 – July 2014 version replaces all earlier versions of IFRS 9 viz., IFRS 9 (2009), IFRS 9 (2010) and IFRS 9 (2013). The good news is that the project is complete. The final version encompasses classification and measurement, new impairment model, revised hedge accounting aspects and replaces IAS 39: Financial Instruments, Recognition & Measurement. Accounting for dynamic risk management is considered as a separate project from IFRS 9 and is still pending.
Salient features of this revised, updated and final IFRS 9 standard that is effective for annual periods beginning on or after 1-Jan-2018 are as follows:
- Logical single classification and measurement approach for financial assets that reflects the business model of the entity;
- Forward-looking expected credit loss model;
- Own credit gains and losses presented in OCI for FVO liabilities instead of recognizing the same in profit or loss. This removes the counter-intuitive paradox of entities booking gains when the value of their own debt falls due to decrease in their own credit worthiness;
- Improved hedge accounting model that reflects the economics of risk management while accounting for the same.
It is disheartening to note that IASB and FASB, being the officially recognized standard setting bodies on both sides of the Atlantic were unable to see eye to eye while finalizing the proposals for impairment model while drafting the standards for financial instruments.
IFRS 9 emerges as a principle based standard where the classification is based on business model and nature of cash flows as opposed to intention and ability to hold which were the bases for classification in the earlier IAS 39 standard. Also IFRS 9 simplifies the reclassification process which again is closely tied to the business model rather than the complicated rule-based reclassification provisions.
- Classification & measurement: Under the new requirements debt instruments can only be measured at fair value through OCI if they are held in a particular business model. That is different to the available-for-sale category today, which is generally an unrestricted option. In order to be classified at fair value through OCI, a debt instrument needs to both have simple principal and interest cash flows and be held in a business model in which both holding and selling financial assets are integral to meeting management’s objectives. This change provides more structure around the classification of these types of assets, which results in better information in the primary financial statements because it directly reflects both the nature of the instrument’s contractual cash flows and the business model in which that instrument is held.
- New impairment model: The new impairment model address the concerns of the ‘incurred loss model’ where the recognition of impairment is considered to be ‘too little and too late’. Measurement of impairment will be the same regardless of the type of instrument held and how it is classified. The new impairment model provides two important pieces of information to assist users of financial statements in understanding changes in the credit risk performance of financial instruments.
- A portion of expected credit losses (a 12-month measure) is recognized for all relevant financial instruments from when they are first originated or acquired. In subsequent reporting periods, if there has been a significant increase in the credit risk of a financial instrument since it was first entered into or acquired, full lifetime expected credit losses would then be recognized.
- The way in which interest revenue is calculated depends on whether an asset is considered to be actually credit-impaired. Initially interest is calculated by applying the effective interest rate to the gross amount of an asset. However, if an asset is considered to be credit-impaired, the calculation changes to applying the effective interest rate to the amortized cost amount (i.e. net of the impairment allowance) of the asset.
New requirements of the impairment model:
- Based on entity’s expected credit losses on financial instruments, recognize expected credit losses at all times and update the changes in the credit risk of financial instruments
- Model is forward-looking
- Eliminates the threshold for the recognition of expected credit losses
- More timely information provided about expected credit losses
- Same impairment model applied to all financial instruments
- 12 month expected credit losses recognized in profit or loss through a loss allowance as soon as a financial instrument is purchased
- Proxy for initial expectation of credit losses
- For financial assets, interest revenue is calculated on the gross carrying amount (before adjusting for the expected credit losses)
- If the credit increases significantly and the resulting credit quality is not considered to be low credit risk, full life-time expected credit losses are recognized
- For financial assets, interest revenue is calculated on the gross carrying amount (before adjusting for the expected credit losses) – Same as for Stage 1
- If the credit increases to the point that it is considered credit-impaired, full life-time expected credit losses are recognized – Same as in Stage 2
- For financial assets, interest revenue is calculated on the amortized cost (gross carrying amount less life-time expected credit losses)
- Financial assets in Stage 3 will generally be individually assessed
- Accounting for changes in ‘own credit’: IFRS 9 requires liabilities that an entity elects to measure at fair value to be recognized on the balance sheet at (full) fair value as changes in fair value provide useful early warning signals of changes in an entity’s own credit risk. However, to address the concerns about accounting for ‘own credit’, IFRS 9 will require the portion of fair value changes caused by changes in the entity’s own credit risk to be recognized in Other Comprehensive Income (OCI) rather than in profit or loss. This will remove the counter intuitive effects that result from accounting for changes in ‘own credit’ through profit or loss.
Counterparty credit risk (CVA) is the risk that the counterparty to a financial contract will default prior to the expiration of the contract and will not make all the payments required by the contract. Obviously exchange-traded derivatives are not subject to counterparty risk as the respective exchange guarantees the settlement of cash flows as per the derivative contract. CVA is a measure that adjusts the risk-free value of an instrument to incorporate counterparty credit risk. CVA can be positive or negative depending on which of the two counterparties is most likely to default and the relative balances due or receivable to each other.
There were some concerns expressed in certain quarters as to whether the Debit Value Adjustment (DVA) should be considered in determining the fair value. Now based on the recent exposure draft announced jointly by IASB and FASB on 28th January 2011 on Offsetting Financial Assets and Financial Liabilities it is amply clear that the DVA also should be recognized along with CVA.
The Institute of Chartered Accountants of India has sent out recently 35 near-final Indian Accounting Standards (Ind-AS) — the Indian version of IFRS – to the National Committee on Accounting Standards (NACAS) for deliberation and finalisation, to emable transition to International Financial Reporting Standards. Over the past year, it has trained accountants on IFRS and issued a draft of the revised Schedule XIV to the Companies Act. It is now left to the regulators to take this forward and legislate on them.
Source: Business Line
The Indian government will stick to its April 1, 2011 deadline for 300 large companies to align their accounts with global financial reporting norms as per the report appearing in Economic Times dated 5th Jan 2011. This is inspite of the concerns raised by an industry lobby. Earlier the government sought fresh comments from the top 300 companies that will converge their accounts with international financial reporting standards (IFRS) from the next financial year before rolling out the new norms.
Indian companies will be asked to follow the norms, which will be rolled out in a phased manner. All BSE-Sensex 30 and NSE-Nifty 50 companies will start following IFRS from April 1 along with all listed companies having a net worth of INR 1,000 crore and above. The Indian government had made a commitment at the G20 summit in 2009 to converge to IFRS from April 1, 2011. Accounting experts welcomed the government’s decision to go ahead with the April 1 deadline.
Full report: Economic Times
Please find below the summary of the Exposure Draft on hedge accounting under IAS 39 issued by IASB on 9th December 2010.
We are all aware that IFRS is principle based while US GAAP is rule based. However, the hedge accounting portions of IAS 39 do contain certain rule based criteria for testing hedge effectiveness. The proposals in the ED seeks to move away from this by making this principle based.
The main objective of ‘hedge accounting’ under the current standards is to mitigate the recognition and measurement anomalies between the accounting for hedged items and to manage the timing of the recognition of gains or losses on derivative hedging instruments used to mitigate cash flow risk. As per the ED the objective is to represent in the financial statements the effect of managing exposures arising from particular risks that affect profit or loss.
So long ‘hedge accounting’ is considered to be a privilege and the entity is supposed to earn such privilege by fulfilling several rigourous conditions. Considering the fact that the new proposal are aimed at the entities to show the effect of managing risks in the financial statements, it will not be surprising if this is made mandatory soon.
||Existing IAS 39 Standard
||Proposed IFRS 9 Standard
||To mitigate the recognition and measurement anomalies between the accounting for hedged items and to manage the timing of the recognition of gains or losses on derivative hedging instruments used to mitigate cash flow risk
||To represent in the financial statements the effect of managing exposures arising from particular risks that affect profit or loss
||A non-derivative financial asset/liability measured at fair value through profit or loss is not eligible for designation as a hedging instrument
||A non-derivative financial asset/liability measured at fair value through profit or loss may be eligible for designation as a hedging instrument
||An aggregated exposure that is a combination of an exposure and a derivative cannot be designated as a hedged item
||An aggregated exposure that is a combination of an exposure and a derivative may be designated as a hedged item
||Risk component separately identifiable and reliably measureable may be designated as the hedged item in a hedging relationship but only for financial items
||Risk component separately identifiable and reliably measureable may be designated as the hedged item in a hedging relationship for non-financial items also
|Hedge effectiveness testing
||Rule-based: The offset is within the range of 80-125 % a hedge is effective and only then it qualifies for hedge accounting
||Principle-based: The hedging relationship should meet the objective of the hedge effectiveness assessment as laid down in the risk management policy of the entity
||On an ongoing basis an entity should assess the effeictiveness of the hedge by retrospective testing
||The assessment relates to expectations about hedge infectiveness and offsetting and therefore is only forward looking.
|No retrospective testing
|Rebalancing of a hedging relationship
||There is no such thing as rebalancing.
||When a hedge effectiveness assessment objective fails an entity can modify the hedge ratio to meet the objective of hedge effectiveness assessment, so long as the risk management objective remains unaltered
|Modifying the hedge ratio is not permitted
|Discontinuing hedge accounting
||If the effectiveness testing fails either prospectively or retrospectively hedge should be discontinued
||Hedge accounting shall be discontinued prospectively only when the hedging relationship ceases to meet the qualifying criteria affecting the risk management activities
|Fair value hedges
||The effective and ineffective portions are taken to the profit and loss
||The gain or loss on the hedging instrument and the hedged item should be recognized in other comprehensive income. The ineffective portion should be transferred to profit and loss
|Time value of options
||The entire fair value of an option including the time value is treated as held for trading and is accounted for at fair value through profit or loss
||When designated, entity should follow specific accounting requirements for accounting the time value of an option
|Net position hedging
||IAS 39 does not allow net positions to be hedged
||Extend the use of hedge accounting to net positions, improving the link to risk management
|Credit derivatives as hedging instrument
||Under the current standards entities using credit derivatives do not achieve hedge accounting as it is operationally difficult if not impossible
||Three alternative approaches of accounting proposed where credit risk is hedged by credit derivatives with separate qualification and discontinuation criteria
|Hedges resulting in non-financial asset/ liability
||Option to either basis-adjust or to route the hedge gain/loss directly in profit or loss from other comprehensive income
||Proposal withdraws the choice and the hedge gain/loss should be subject to basis-adjustment
Are weather derivatives covered by IAS 39 or are they insurance contracts?
Contracts that require payment only if a particular level of the underlying climatic, geological or other physical variables adversely affects the contract holder are insurance contracts and as such are outside the scope of IAS 39.
However contracts that require a payment based on a climatic, geological or other physical variable that is not specific to a party to the contract are commonly described as weather derivatives and by virtue of IFRS 4 these contracts are not insurance contract. Hence the weather derivatives are within the scope of IAS 39.
As per US GAAP, Cash flow hedge accounting for a foreign currency debt is permissible using a FX forward contract to cover the Foreign Exchange risk . Section 815-20-25-28 is quoted below:
“If the hedged item is denominated in a foreign currency, an entity may designate any of the following types of hedges of foreign currency exposure:
a. A fair value hedge of an unrecognized firm commitment or a recognized asset or liability (including an available-for-sale security)
b. A cash flow hedge of any of the following:
1. A forecasted transaction
2. An unrecognized firm commitment
3. The forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability
4. A forecasted intra-entity transaction.
c. A hedge of a net investment in a foreign operation.”
Such a cash flow hedge is specifically permitted by virtue of Section 815-20-25-29 which is quoted below:
“The recognition in earnings of the foreign currency transaction gain or loss on a foreign-currency-denominated asset or liability based on changes in the foreign currency spot rate is not considered to be the remeasurement of that asset or liability with changes in fair value attributable to foreign exchange risk recognized in earnings, which is discussed in the criteria in paragraphs 815-20-25-15(d) and 815-20-25-43(c).
Thus, those criteria are not impediments to either of the following:
a. A foreign currency fair value or cash flow hedge of such a foreign-currency- denominated asset or liability
b. A foreign currency cash flow hedge of the forecasted acquisition or incurrence of a foreign currency-denominated asset or liability whose carrying amount will be remeasured at spot exchange rates under paragraph 830-20-35-1.
Is this type of a transaction eligible as a Cash Flow hedge under IAS 39 of IFRS? …read more on Forum