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AAI Implications of IFRS on Recognition and Measurement of Financial Instruments


Introduction
Indian companies are now gearing up for a transition to International Financial Reporting Standards (IFRS) and one of the most challenging standards to understand and apply is IAS 39.  The objective of this standard is to establish principles for recognizing and measuring financial instruments. For companies which are significant investors, borrowers or users of financial instruments, the standard is going to raise significant issues. The first-time adopters will have to change the way they account for financial instruments and this will involve substantial changes to systems, processes and documentation.

IAS 39 came into existence in December 1998 and has undergone a number of amendments since then. The major changes brought about by IAS 39 were to increase the use of fair values for measuring and reporting financial instruments and to address the important issue of financial derivatives, requiring that these be formally recognized and measured at fair value in most cases.

In India, companies are not required to follow an accounting standard which deals with financial instruments in a comprehensive manner. Effective 1 April 2007, ICAI has issued AS30, a standard for financial instruments which is in line with IFRS 39 & 7. However, these are recommendatory in nature and would become mandatory only after 2 years from the effective date. Companies in India who have not yet transitioned IFRS or are not early adopter of AS30 will have to bring about the following changes in the way they treat their financial instruments-

1.   Financial Instruments Categorization

Under Indian GAAP, current investment/financial asset is carried at lower of cost and fair value whereas long term investment/financial asset is carried at cost less impairment, if any.  Liabilities are normally carried at amount received. There is a different set of standards for specific sectors like banking where investments are required to be classified as held to maturity, trading and available for sale. However, the classification criteria and measurement requirements differ from IFRS.

Under IFRS, companies will have to reclassify all their financial assets/liabilities in accordance with IAS 39, irrespective of their classification under Indian GAAP.

  • A financial asset would be classified as a held-to-maturity investment if, at the date of transition, there is a positive intent and ability to hold it to maturity and the asset does not meet the criteria for classification as ‘loans and receivables’.
  • A non-derivative financial asset or liability would be classified as held for trading if the asset or liability was acquired or incurred principally for the purpose of selling or repurchasing in the near term or for which there is evidence of a pattern of short-term profit-taking.
  • Derivatives not designated as hedging instruments would be classified as held for trading.
  • Any financial asset can be classified as available for sale at the date of transition and any financial asset or liability can be designated as at fair value through profit or loss provided those assets and liabilities meet the criteria for such designation. However, once such classification has been made, the asset is not allowed to be reclassified.

Once a financial asset/liability is identified, it needs to be classified into one of the following categories. These categories determine how the financial instrument is measured subsequent to its recognition and where any changes in carrying value need to be reported i.e. in income statement or equity.

Category Measurement basis

Reporting of changes
carrying value

Financial assets/liabilities held for trading
(Includes derivatives except those designated as
hedging instruments) or designated as assets at fair value through profit or loss
Fair Value Income Statement
Available-for-sale financial assets Fair Value Equity
Loans and receivables Amortized Cost Income Statement
Held-to-maturity investments Amortized Cost Income Statement


Financial Liabilities not categorized as held for trading are carried at amortized cost with changes reported in equity.

2. Classification between Equity and Liabilities
Under Indian GAAP there is no mandatory requirement for instruments to be classified based on substance rather than form. For example, preference shares are treated as capital even though they may, in substance, be a liability in some cases. IAS 39 is likely to change the way some on these instruments are categorized. Some of these changes are -

  • Classification as a financial liability or an equity instrument is according to the substance of the contract, not its legal form. The enterprise must make the decision at the time the instrument is initially recognized. The classification is not subsequently changed based on changed circumstances.
  • Once an instrument is classified as equity and recorded in the balance sheet, it is not measured again going forward. Liability instruments are treated as per the categorization provided in paragraph 1 above. 
  • Compound Instruments: Some financial instruments including convertible instruments have both a liability and an equity component from an issuer's perspective.
  • In such cases, IAS 32, a companion to IAS39, requires that the component parts be accounted for and presented separately as liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or any other event that changes the likelihood that the conversion option will be exercised. In case of inception date accounting, the issuer of the compound instrument first computes the financial liability component and the residual value (issue amount reduced by the fair value of the financial liability) will be equity.


3. Derivatives and Embedded Derivatives
In India, there is no specific guidance on derivatives (other than AS30, which is not mandatory). AS 11 deals with Foreign Currency Forwards whereas “Guidance Notes on accounting for Equity Index and Equity Stock Futures Options” deals with these specific derivatives. As a result, a whole range of over-the-counter and market traded financial derivatives like interest rate swaps, forward rate agreements, commodity futures, currency options etc remained completely unattended.  Under IFRS, derivatives would be accounted as follows-

  • Derivatives which are not designated as hedging instruments are carried at fair value and changes in the carrying amount are reported in income statement.
  • Derivatives might also exist as embedded instruments in a host contract. IAS 39 requires such embedded derivatives to be split from the host contract and accounted for separately, if certain predefined conditions are met.
  • Most often derivatives would be designated as hedging instruments. Accounting for a derivative instrument designated as a hedging instrument would depend on the categorization of the hedge and changes in fair value may be reported in equity or income statement depending on the hedge classification.
  • Hedge Accounting- “Hedge accounting” came into existence to address the mismatch in accounting of the hedged instruments and allows entities to override the normal accounting treatment for derivatives (fair value through income statement) or to adjust the carrying value of assets and liabilities.
  • Under IAS39, a hedge relationship would qualify for hedge accounting if it meets certain predefined conditions including requirement of formal documentation of hedging relationship and achievement of effectiveness tests – to be met at inception and throughout the term of the hedge relationship (effectiveness should fall within a range of 80%-125% over the life of the hedge).

Following table summarizes various categories of hedges and their accounting treatment –

Hedge Type Hedge Example Accounting Treatment
Fair Value Hedge Hedge of change in fair value of a firm commitment, fall in value of an available for sale equity investment etc. Recognize in income statement directly
Cash Flow Hedge Hedge of a highly probable forecasted
transaction or future cash flows related to existing assets/liabilities (like interest payment/receipt from a variable loan)
Recognize in equity. Reclassify from equity to income statement on the date hedged transaction affects income statement
Net Investment Hedge Hedge of an investment in subsidiary Recognize in equity. Reclassify from equity to income statement when the investment is disposed.



4. Financial Instrument Measurement: Fair Value
Under IAS 39, subsequent to the initial recognition, financial assets and liabilities (except certain instruments which are subject to particular measurement requirements) should be measured at fair value.

IAS 39 defines fair value as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. When determining the fair value of a financial instrument, the following hierarchy needs to be applied-
 

5. Conclusion
For Indian companies transitioning to IFRS, IAS 39 brings greater transparency, particularly in the reporting of derivatives and their use in risk management. However, along with the benefit of increased transparency, IAS 39 also brings along greater challenges and issues like-

Increased volatility – With more and more assets being carried at fair value, the income and net assets on the balance sheet would become increasingly volatile. Also, certain instruments may be reclassified from equity to liability or vice versa. This may impact the loan covenants and capital structure of the company. once not traded in the market, monitoring the hedge effectiveness and providing new disclosure information on market, credit and liquidity risks. This would require companies to enhance their skills and systems or rely on third parties to provide these services.

Need for enhanced skills and systems - There would be a need to calculate the fair value of derivatives, especially the once not traded in the market, monitoring the hedge effectiveness and providing new disclosure information on market, credit and liquidity risks. This would require companies to enhance their skills and systems or rely on third parties to provide these services.

Hedging strategies – Companies using old methods of hedging might not be able to account for them as a hedge under IAS 39. Hence companies would have to either change their hedging strategies or change the way they account for their hedges.

Whatever be the benefits and challenges that IAS 39 offers, its adoption as a part of IFRS standard

 

 

 

 

 

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