FINANCIAL INSTRUMENTS

IMT HYDERABAD
THE JOURNEY

 Constitutes a significant item in financial statements of most entities (all industries)

 Sophistication of financial markets has increased significantly over the years – new innovative and complex
financial instruments have been introduced
 For many financial instruments, historical information not useful for economic decision making
 India among the first few countries to adopt IFRS 9 (Ind-AS 109)
 Highly judgmental standard and involves lots of interpretations
KEY PRINCIPLES OF THE STANDARD
Key principles of the Standard

Harmonisation of markets

Increased complexity Many other

All derivatives financial
are instruments
measured at measured
Detailed disclosures fair value at fair value

Use of fair values

Measurement of the hedging
instrument
Largely rules based
IMPACT OF IFRS 9

 Response to the global financial crisis

 More income statement volatility
 Earlier recognition of impairment losses on receivables and loans, including trade receivables
 Significant new disclosure requirements
 New hedging requirements
BALANCE SHEET – ASSET SIDE
BALANCE SHEET – LIABILITY SIDE
 SCOPE
Applicable
Standard
Interests in subsidiaries 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 IFRS 2

share-based payment transactions
Rights and obligations under insurance contracts IFRS 4
(except embedded derivatives and certain financial guarantees)

Rights and obligations under leases (except embedded derivatives and impairment) IAS 17

Certain loan commitments IAS 37

 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
Cash
Equity instrument of another entity
Contractual right to receive cash or
another financial asset
Contractual right to exchange financial
assets or liabilities under conditions those
are potentially favourable to the entity
Contract that will or may be settled in
entity’s own equity instruments
Financial
Equity instrument
liability
Contractual obligation to deliver cash or Contract evidencing
another financial asset or to exchange a residual interest in the assets of an entity
financial asset or liabilities after deducting all of its liabilities
Certain contracts settled in the entity’s
own equity
Except for certain puttable financial
instruments and obligations arising only
upon an entity's liquidation
DEBENTURES

Issued Debentures

Redeemable Convertible Redeemable or Convertible

FL E.I. Option with Option with

holder issuer

FL E.I.
NON FINANCIAL INSTRUMENTS
Non Financial Instrument

with N.S.O. No N.S.O.

A B C D Non -FI

Net Settlement Option Past history of net P & S are immediate Asset is readily convertible
settlement to cash

Except it leads to
F.I. Accounting
mismatch , then
treat it as a F.I.

Whether YES
Non -F.I.
Entity has Receipt/delivery
written NO of Non FI is as
YES
Put/Call per expected p/s
Option /usage F.I.
requirements NO
F.I.
COMMODITY CONTRACTS

 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
 EXAMPLES

 Bills payable  Creditors

 Treasury bills  Convertible bonds
 Loans payable  Outstanding liabilities
 Commercial papers  Exchangeable bonds
 Deposits received  Advances received for goods
 Bank balance  Deferred taxes
and services
 Trade payables  Servicing assets
 Investment in equity shares  Income taxes
 Perpetual debt instrument  Derivatives
 Investment in  Warranty obligations
issued
bonds/debentures  Preferred stocks
 Tangible fixed assets  Gold
 Loans/Deposits given  Cumulative preferred stock
 Patent  Gold bonds held
 Debtors  Equity
 Goodwill  Financial guarantee
 Inventories  Treasury shares
 Deferred revenue  Finance lease
 Prepaid expenses  Interest receivable and
expenditure  Operating lease
 Loan commitments payable
 Bills receivables  Commodity contracts
CLASSIFICATION REQUIREMENT
BUSINESS MODEL AND SSPI TEST
COMPARISON WITH IAS 39
FINANCIAL ASSETS

 Amortized cost
 Fair value through profit or loss
 Fair value through other comprehensive income
DEBENTURES EXAMPLE
 FINANCIAL ASSETS

 Amortized cost
 Initial recognition will be at FV plus transaction costs
 Subsequent measurement is at amortized cost using effective interest rate
 Example – Investment in bond with FV of $1,000, coupon rate 12% at $891. Brokerage commission is $8. Bond tenure is 5 years

 Fair value through other comprehensive income

 Initial recognition will be at FV plus transaction costs
 Subsequent measurement is at FV with difference between CV and FV recorded in OCI
 Interest income will go to income statement
 Example – Same as 1, FV at YE 1 is $906,YE 2 is $910 and YE 3 the investment is sold for $940

 Fair value through profit or loss

 Held for trading purposes (All derivatives)
 Initial recognition is at FV, transaction cost goes to income statement
 Subsequent measurement is at FV with difference between CV and FV recorded in income statement
EQUITY INVESTMENT

 Can be measured at amortized cost?

 Measured at FVTPL (An entity may make an irrevocable election upon initial investment to measure it at
FVTOCI)
 Dividend income will go to income statement
BUSINESS MODEL AND SPPI TEST ILLUSTRATIONS
FINANCIAL LIABILITIES

 Amortized cost
 Fair value through profit or loss
LOAN GIVEN TO EMPLOYEES AT DISCOUNTED RATE

 Class discussion
CONVERTIBLE BOND

 Class discussion
IMPAIRMENT

 FVTPL
 FVTOCI
 Amortized cost asset (example)
 Expected loss model instead of incurred loss model
IMPAIRMENT
THE NEW IMPAIRMENT MODEL
RECLASSIFICATION
 RECLASSIFICATION OF FINANCIAL ASSETS

 Required by change in the business model

 Audit concerns No relass for
 Applied prospectively from the reclassification date FL
 Amortized cost asset –
 Determine the FV of the asset and difference will be taken to P&L >>> FVTPL
 Determine the FV of the asset and difference will be taken to OCI >>> FVOCI

 FVTPL
 Consider the FV as opening amortized cost and do the normal amortization >>> Amortized cost
 No change in FV but subsequent measurement will be through OCI >>> Amortized cost

 FVTOCI
 No change in FV but subsequent measurement will be through P&L also balance from OCI will move to income statement >>> FVTPL
 Reduce the FV by the balance from OCI and considered to be FV and subsequent measurement via amortized cost >> Amortized cost
 DERECOGNITION OF FINANCIAL ASSETS

 Upon expiry of the right to receive the contractual cash flows

 Upon sale of the asset
 Partial transfer (Portion of the stream of cash flows is transferred)
 Securitization (interest and principal)
 Determine fair value of both the assets
 Split the carrying value of the asset based on the FV determined
 Derecognize the portion sold
DERIVATIVES

Three characteristics

Fair value changes in response

to changes in underlying
 Interest rate,
 Security price, No or little initial Settled
net investment at a future date
 Commodity price,
 Foreign exchange rate,
 Credit rating
FINANCIAL STATEMENT IMPACT

 All derivatives and certain embedded derivatives are reported on the balance sheet at fair
value

 Changes in fair value of derivatives are recorded through earnings, unless certain hedge
designations are elected

 Different accounting for:

 Fair value hedges
 Cash flow hedges
 Foreign currency hedges
EXAMPLES OF DERIVATIVES AND UNDERLYING

Main pricing-settlement variable

Type of contract
(underlying variable)
 Interest rate
 Interest rate swap
 Currency rates
 Currency forward
 Commodity prices
 Commodity option
 Credit rating
 Credit swap
 Equity prices
 Purchased or written stock
option (call or put)
EMBEDDED DERIVATIVES

 What are they? / How to identify?

 An implicit or explicit term in a contract that makes a portion of the contract behave like a derivative

Changes
Instruments
cash flows
with
conversion
features

Transactions
in “third
currency”

Option to prepay
debt
EMBEDDED DERIVATIVES - SEPARATION
 When to separate?
 The economic characteristics and risks of the embedded derivative are not closely related to those 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 with changes in fair value recognised in profit or loss

 Separating embedded derivative

 No gain or loss on initial bifurcation
 Initial carrying amount of the host contract will be equal to the difference between the carrying amount
of hybrid contract and the fair value of the embedded derivative.
IFRS 9
requires no
separation
HEDGING

Arson Co, an Indian subsidiary, enters into a contract to acquire new machinery from Beta, an
American company. The cost of the machinery is $ 50,000 and is payable in one year’s time.
Arson’s operating currency is rupees and the current exchange rate is $ 1:RS.40.

Arson faces the exchange risk associated with the contract. To eliminate the risk, Arson enters
into a forward contract to acquire $50,000 in one year’s time at the current exchange rate.

In one year’s time, when Arson has to pay $50,000 to Beta for the machinery, it can exercise
the forward contract. Arson will therefore, pay Rs.2,00,000 for the machinery irrespective of
whether the exchange rate has moved up or down. This is known as hedging
HEDGE ACCOUNTING

 Entities use a risk management technique called hedging, whereby the entity tries to reduce the impact of future
potential costs or losses

Hedge accounting (HA) is technique

That
Changes the normal basis for recognizing gains & losses
On
Associated hedging instruments and hedged items
So That
Both are recognized in profit and loss account in the same accounting
period
BENEFITS OF HEDGE ACCOUNTING

Reporting the effects in the same period to avoid a mismatch in

timing of gain and loss recognition:

1 2 Cum
Hedged item 0 A -20 -20
Hedging instrument 20 B 0 20
20 -20 0

A Accelerate recognition of gain or loss on hedged item

B Defer recognition of gain or loss on hedging instrument

HEDGE ACCOUNTING
 QUALIFYING FOR HEDGE ACCOUNTING

 There has to be a hedged item specifically designated

 There has to be a hedging instrument
 There has to be a relationship between the hedged item and the hedging instrument with formal documentation.
 The relationship should be effective so as to offset the effects on profit or loss of changes in the fair value of the
hedging instrument and the hedged item.
 HEDGED ITEM

 The hedged item is the underlying item that is exposed to the specific risk that the entity has chosen to hedge
 To qualify for designation the hedged item should create an exposure to risk that ultimately affects profit or loss
HEDGING INSTRUMENT

 The following can be designated as hedging instruments:

 derivatives with third parties
 non-derivatives carried at FVTPL
HEDGE ACCOUNTING MODELS

Fair value hedges

 Hedge of exposure to changes in fair value of:
 a recognised asset or liability; an unrecognised firm commitment; or an identified portion of any of
these two;
 that is attributable to a particular risk; and
 could affect profit or loss

Cash flow hedges

Hedge of exposure to variability in cash flows that is:
attributable to a particular risk associated with a recognised asset or liability or a
highly probable forecast transaction; and
could affect profit or loss

Hedges of a net investment in a foreign operation

HEDGE ACCOUNTING MODELS

 Coffee house has fixed the value of its tea inventory entering into a future contract.
Here, the entity is hedging the risk of changes in the tea inventory’s overall fair value.This is an example of a
fair value hedge that often occurs in practice.

 Entity Z, which has a highly probable sale of a commodity in the future at the then prevailing market
price, ‘fixes’ the selling price of the goods by entering into a future contract.
By doing this, the entity is hedging the risk of variability in the cash flows to be received on the sale due to
changes in the goods market price. This is an example of Cash Flow Hedge.
HEDGE ACCOUNTING MODELS
FAIR VALUE HEDGE ACCOUNTING MODEL
Measurement of hedging Changes in fair
instrument value

Measurement of hedged item Profit

or
loss

(*) This applies even if a hedged item is otherwise measured at cost

EXAMPLE

Example :
 A Tea house fixed the value of its tea inventory by entering into a future contract.

 Here the entity is hedging the risk of changes in the tea inventory’s overall fair value.
This is an example of a fair value hedge that often occurs in practice.
FAIR VALUE HEDGE
FAIR VALUE HEDGE
FAIR VALUE HEDGE
CASH FLOW HEDGE ACCOUNTING MODEL

Changes
Measurement of in fair value
hedging instrument
Other
Fair value Effective
comprehensive
income (OCI)

(*)

Profit
or loss

(*) Based on timing of earnings impact of hedged item (e.g. cost of sales, depreciation, interest)
EXAMPLE

Example :
Entity X, which has a highly probable sale of a commodity in the future at the then prevailing market price, ‘fixes’ the selling price of the goods by
entering into a future contract.

By doing this, the entity is hedging the risk of variability in the cash flows to be received on the sale due to changes in the good’s market price.
This is an example of a cash flow hedge.
CASH FLOW HEDGE
CASH FLOW HEDGE
CASH FLOW HEDGE
CASH FLOW HEDGE
CASH FLOW HEDGE
CASH FLOW HEDGE
CLASS DISCUSSION
HEDGES OF A NET INVESTMENT

 Must meet requirements for hedge accounting

 A net investment hedge is a hedge of the foreign currency exposure on a net investment in a foreign operation using a derivative, or a non-
derivative monetary item, as the hedging instrument
 Effective portion of gain or loss on hedging instrument  recorded in the same manner as the foreign currency translation gain or loss i.e., in OCI
 Ineffective portion of gain or loss on hedging instrument  recognised in profit or loss
 Reclassified from OCI to profit or loss as a reclassification adjustment upon disposal of net investment
DEBT VS EQUITY

Is there a contractual obligation that the issuer cannot avoid?

Yes No Part

Liability Equity Compound instrument

 Determine liability component
 fair value
 include embedded derivatives
 Equity is residual
 No gain or loss on separation

 Classification assessed at initial recognition and generally not subsequently revised for changes in circumstances (except for puttable financial instruments and obligations arising on
liquidation)
 However, subsequent change in terms and conditions of instrument may require reclassification
DERIVATIVE CONTRACTS THAT WILL OR MAYBE SETTLED IN OWN
EQUITY INSTRUMENTS
Only fixed-for-fixed gross physical Equity
Yes Obligation or potential No
settlement, i.e. fixed number of shares instrument
obligation to purchase
for fixed amount of cash or other
own equity for cash /
financial instruments
other financial assets

No
Yes Yes
Only net settlement (i.e.
net-cash or net-shares)

No Derivative asset
/ liability Financial liability for
Obligation or potential present value of
obligation to purchase own redemption amount
equity for cash / other
financial assets No

Yes

Financial liability
for present value of
redemption amount