financial instruments ifrs 9 - wirc-icai

Financial Instruments Standards

IFRS 9 IAS 39

Presented by CA. Pooja Gupta – B.Com, FCA, LL.B, CS, Masters in Finance (Germany)

Financial instruments

Presentation

Recognition and measurement


Derecognition

Hedge accounting

Disclosures


Derivatives Most Financial


Derivatives recognized

on the Balance Sheet

Most Financial Assets

measured at

“Fair Value”

Hedge Accounting


Financial instruments are defined as any contract that gives rise to:

- financial asset of one entity and


Financial Instruments: Scope & Definition

- financial asset of one entity and

- financial liability or equity instrument of another entity.

Scope:

IAS 39 applies to all entities but not to all financialinstruments


Financial assets and liabilities

FIN

AN

CIA

L A

SS

ET

S

•Cash;

•Equity instrument of

another entity;F

INA

NC

IAL L

IAB

ILIT

IES

• Contractual obligation

to deliver cash or

another financial

asset or to exchange

EQ

UIT

Y

INS

TR

UM

EN

T

• Contract evidencing

residual interest in

the assets of an entity

after deducting all its

Financial Instruments Standards F

INA

NC

IAL A

SS

ET

S

another entity;

•Contractual right to receive

cash or another financial


financial assets or financial

liabilities under potentially

favorable conditions;

•Certain contracts settled in

entity’s own equity. FIN

AN

CIA

L L

IAB

ILIT

IES


financial assets or

financial liabilities

under potentially

unfavorable

conditions;

• Certain contracts

settled in entity’s own

equity.

EQ

UIT

Y

INS

TR

UM

EN

T

after deducting all its

liabilities.


Presentation of Financial Instruments


• Presentation sets out principles for –

� Debt v/s Equity;


� Compound Financial Instruments;

� Treasury shares;

� Offsetting financial assets and financial liabilities

Presentation: Debt v/s Equity


Yes No Part

Is there a contractual obligation that the issuer cannot

avoid?


(Para 15 of IAS 32)

� Assess at initial recognition

� Classification continues until disposal

� Determine liability component

� Equity is residual

� No gain or loss

Yes

Liability

No

Equity

Part

Compound instrument

Presentation: Compound Instrument


• IStaR Ltd. issues 1000 bonds convertible intoits own shares in 3 years. The bonds areissued at par with a face value of INR 100/-per bond. Interest is payable annually atnominal interest at 6% p.a. Each bond isconvertible at anytime up to maturity in 125equity shares. When bonds are issued the

• PV of the principal 100,000/-payable at the end of 3 yrs (77,200)

PV of the interest 6,000/-payable annually for 3 years (15,186)


equity shares. When bonds are issued theprevailing market interest rate for similar debtwithout conversion options is 9% p.a.

• Solution:

Under this approach, the liability element isvalued first, and the difference between theproceeds of the bond issue and the fair valueof the liability is assigned to the equitycomponent. The present value of the liabilitycomponent is calculated using a discount rateof 9%, the market rate for similar bonds withno conversion rights.

3 years (15,186) ------------

Total Liability Component (92,386)

• Proceeds of the Bond 100,000------------

• Equity component (bal. fig) 7,614=======

• Discounting factor @ 9% 1 year 0.917 2 year 0.842 3 year 0.772


� Component of hybrid (combined) instrument that includes a non- derivative “host contract” – with

the effect that some of the cash flows of the combined instrument vary in a way similar to a stand

alone derivative.

HOST CONTRACTHOST CONTRACT

Debt

Executory

Contract

Lease

Insurance

Equity

EMBEDDED DERIVATIVE

FX Option Inflation index Commodity index Equity index



• Subordinated loan with equity kicker

IStaR bank has granted a 20 year subordinated loan of ` 100 million to a start –up company at 7% which is below the market yield. As per the loan agreement,the borrower company shall issue 1% of its equity shares outstanding on thedate of listing at 70% of the listing price apart from annual payment of interestdate of listing at 70% of the listing price apart from annual payment of interestand repayment of principal. Is the equity kicker an embedded derivative?

Analysis – It is an embedded derivative, because the host contract is a debtinstrument and it is an option based derivative to exercise for 1% of equityshares of the borrower company at a strike price. The option can be valuedbased on current valuation of equity . It should be segregated from the hostcontract.


Is the Host contract a Financial Asset within the scope of IFRS 9?



DO NOT SEPARATE SEPARATE if:

• Economic characteristics not closely related • Separate instrument would meet the definition of derivative• Hybrid instrument not classified as FV through P or L


Whether an embedded derivative is required to be separated is assessed when the entity first enters into the contract. Subsequent reassessment is prohibited.

Conditions for separation:

Is the contract

Split an

d acco

unt sep

arately


Is the contract

carried at fair

value through

profit or loss

Will it be a

derivative if it was

a freestanding?

Is it closely

related to the

host contract

Do not split the embedded derivative

NoNo YesYes NoNo

NoNoYesYes YesYes

Split an

d acco

unt sep

arately



Question 1

A German company agrees to sell and deliver its produced cars to a car retailer inUzbekistan in two months time. The contract is denominated in USD. USD is thecommonly used currency in Uzbekistan for transactions of this kind since the localcurrency is relatively unstable. Does the contract contain an embedded derivativethat should be separated?


currency is relatively unstable. Does the contract contain an embedded derivativethat should be separated?

Question 2

A Norwegian company agrees to sell oil to a company in France. The oil contract isdenominated in Swiss francs (oil contracts are routinely denominated in US dollarsin international commerce). The functional currency of the Norwegian company isNorwegian kroner and that the functional currency of the French company is Euro.Is there an embedded derivative that should be separated ?


Solution 1

No. The contract will not contain an embedded derivative that needs to be separatedout under the Standard. This is because (of the assumption that) sales of cars andother durables in Uzbekistan are commonly denominated in USD (as a relatively


other durables in Uzbekistan are commonly denominated in USD (as a relativelystable and liquid) due to the country’s own currency being unstable

Solution 2Yes. The Norwegian company regards the supply contract as a host contract inNorwegian kroner with an embedded foreign currency forward to sell Norwegiankroner and purchase Swiss francs. The French company regards the supply contractas a host contract with an embedded foreign currency forward to sell Swiss francsand purchase Euro


Question 3

A manufacturer enters into a long-term contract to purchase a specified quantity of acommodity from a supplier. In future periods, the supplier will provide the commodityat the current market price but within a specified range, for example, the purchaseprice may not exceed 120 per unit or fall below 100 per unit. The current market priceat the inception of the contract is 110 per unit. Is there an embedded derivative, which


at the inception of the contract is 110 per unit. Is there an embedded derivative, whichwould require separation?

Question 4

Company A issues a debt instrument on which it pays interest indexed to the price ofgold. Is there an embedded derivative that should be separated and accounted for asa derivative?


Solution 3

No. From the manufacturer’s perspective, the price limits specified in the purchasecontract can be viewed as a purchased call on the commodity with a strike price of120 per unit (a cap) and a written put on the commodity with a strike price of 100 perunit (a floor). At inception, both the cap and floor on the purchase price are out of the


120 per unit (a cap) and a written put on the commodity with a strike price of 100 perunit (a floor). At inception, both the cap and floor on the purchase price are out of themoney. Therefore, they are considered closely related to the host purchase contractand are not separately recognised as embedded derivatives

Solution 4

Yes. According to the Standard, a commodity-indexed interest would not beconsidered closely related to a host debt instrument. Therefore, Company Aseparates the embedded derivative, a forward indexed to the price of gold, from thehost debt instrument and measures the derivative at fair value

Ind AS 109 3 Appendices6 Chapters

Financial Instruments – Ind AS 109Financial Instruments Standards

Defined Terms

Application

Guidance

Amendments to other standards

“If you don’t know where you’re going you’re highly unlikely to get there”


Chapter 1 Objective

• To establish principles for the financial reporting of

financial assets and financial liabilities



financial liabilities

Chapter 2Scope

• Applies to all entities but Not all Financial

Instruments

All financial assets and financial liabilities, including derivatives,



All financial assets and financial liabilities, including derivatives,

should be recognised when the entity becomes party to the contractual provisions

of financial instrument

Effective from Guidance on fair value

in other IAS / IFRS

supersededTo set



Objective

To Define Fair

Value

To set

Framework

for measuring

Fair Vale

Require

Disclosures

HOW? WHEN?IFRS

13

IFRS

9

Fair Value - Definition• the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction

between market participants at the measurement date

Exit PriceMarket based and not entity

based



Determine

Asset / Liability (Unit of account)

Non-Financial Asset (Highest and best use)

Principal / Most

advantageous market

Valuation techniques (Fair Value hierarchy)

Stand-alone asset/ liability

Group of assets/ liabilities



Characteristics

Condition + Location

Restrictions to sell / to transfer

“What gets measured gets

done”



Principal

Market =With the greatest

volume or activity

done”

When no principal market Most advantageous market

Maximize amount to Minimizes amount



Maximize amount to

sell asset

Minimizes amount

to transfer liabilities

Consider

Transaction Costs Transport Costs

To set most advantageous market

To set fair value

When it is extinguished



DischargedExpiresCancelled

• A securitisation is a transaction that transforms a financial asset(s)into securities


• Intent is often to achieve derecognition of the financial assetssecuritized

• Securitised assets often are transferred to a special purpose entity(SPE)


Part or entire asset?

Rights to cash flows expired? Derecognition

Rights to cash flows transferred?

Consolidation

NO

YES

NO NO



Pass through arrangement? Continue to recognize

DerecognitionSubstantially all risks and rewards transferred?

Substantially all risks and rewards retained?

Control retained?

Derecognition

NO

YES

NO

NO

NO

YES

YES

YES

Continue to recognize

YES

NO

Financial Assets

FA at Amortised CostFA at Fair Value

through OCIFA at Fair Value through

Profit and Loss



FA at Amortised Cost

Fair Value + Transaction Costs

Amortised Cost using EIR

Profit or Loss

through OCI

Fair Value

Fair Value

OCI

FA at Fair Value through Profit and Loss

Fair Value

Fair Value

Initial

Measurement

Subsequent

Measurement

Gain / Loss

Financial Liabilities

FL at Amortised CostFL at Fair Value through

Profit and Loss



FL at Amortised Cost

Fair Value + Transaction Costs

Amortised Cost using EIR

Profit or Loss

Profit and Loss

Fair Value

Fair Value

Initial Measurement

Subsequent Measurement

Gain / Loss

DerivativesDerivatives are instruments with all three of the following characteristics

� Value changes in response to changes in specified underlying price/ index (e.g. interest rate, FX rate, share price)


� Requires no or little net investment

� Settled at a future date

Examples of derivatives:

� Forward FX contract

� Interest rate swap

� Collar and Caps


Purchase of Buy USD - Sell INR forward contract (Assume Incremental Borrowing rate @ 6% or alternatively use WACC)

Forward Spot

Forecast purchase $ 10000

1.10.2010 45.6 45.20 6 month

31.12.2010 45.5 45.10 3 month


31.3.2011 45.00 0 month

Journal Entries

1.10.2010 Entry with zero amount Discounted Undiscounted

31.12.2010 Unrealized P & L A/c Dr 985.22 -985.22 -1,000

Forward Liability Cr 985.22

31.3.2011 Unrealized P & L A/c Dr 5,014.78 - -6,000

Forward Liability 5,014.78

31.3.2011 Purchases Dr 4,50,000

To Bank 4,50,000

Forward Liability Dr 6,000.00

To Bank 6,000.00 4,56,000



Initial recognition amount -

Amortised cost =

Principal repayments

-/+

Accumulated interest -

Impairment reduction


Amortisation is calculated using the effective interest rate method.

The effective interest rate is defined as “the rate that exactly discounts estimated future cash flows through the expected life of the financial instrument or, where appropriate, a

shorter period to the net carrying amount of the financial asset or financial liability”.


Year No EIR EIR

Interest Prin EMI O/s Interest Prin EMI O/s Txn

Costs

1 50,000 81,899 131,899 418,101 48,106 83,793 131,899 421,207 1,894


1 50,000 81,899 131,899 418,101 48,106 83,793 131,899 421,207 1,894

2 41,810 90,089 131,899 328,013 40,124 91,775 131,899 329,432 1,686

3 32,801 99,097 131,899 228,915 31,382 100,517 131,899 228,915 1,424

4 22,892 109,007 131,899 119,908 22,892 109,007 131,899 119,908 0

5 11,991 119,908 131,899 0 11,991 119,908 131,899 0 0

159,494 500,000 154,494 505,000 5000


Radia & Raja Ltd. issued a zero coupon bond of par value 100 at 68; maturity 5 years.

Years Cash flows Interest Amortized Cost Journal Entry

Bank A/c Dr 68


0 68 68

Bank A/c Dr 68Zero Coupon Bond A/c 68

1 0 5.453 73.4526

2 0 5.89 79.3424

3 0 6.362 85.7045

4 0 6.872 92.5767

5 -100 7.423 100

IRR 8.02%


Active Market � Unadjusted published price quotations


No Active Market � Valuation techniques (DCF, Black Scholes, etc)

Fair Value at Cost � Unquoted Equity Investments – impairment loss

What’s a Hedge?



“Measurement” mismatch (between the hedged item and hedging instrument)

“Recognition” mismatch (between the hedged item and hedging instrument)


hedging instrument)

�� Hedged item measured at amortised cost

�� Hedging instrument measured at fair value

hedging instrument)

�� Hedged item not yet recognised in the balance sheet or income statement

�� Hedging instrument measured at fair value


Risk being hedged is the change in the ‘fair value’ of or identified portion of an asset, liability or unrecognized firm commitment

Hedging instrument –


Hedging instrument –

Change in fair value

Hedged item –

Adjust the carrying amount

INCOME

STATEMENT



Risk being hedged is exposure to variability in ‘cash flows’ of an asset, liability or unrecognized firm commitment

Hedging instrument

Changes in fair value


Recycled when hedged items affect earnings

Effective Portion -

EQUITY (OCI)

(Cash flow Hedge Reserve)

Ineffective Portion –

INCOME STATEMENT

Hedge relationship must be documented at inception

The criteria for hedge accounting is onerous and have system implications for all

entities. Hedge Accounting is OPTIONAL and management should consider the

cost and benefits to use it.


• Risk management objective and strategy for the hedge

• Identification of the hedging instrument

• The related hedged item or transaction

• The nature of the risk being hedged

• How hedging instrument’s effectiveness will be assessed

Hedge must be expected to be highly effective at inception and subsequent periods

• Hedge effectiveness must be tested regularly throughout its life

• Effectiveness must fall within the range of 80% - 125% over the life of the hedge

In the case of hedging future cash flows, there must be a high probability of that cash flow occurring


Effectiveness Test: Prospective & Retrospective

• IAS 39 does not specify a single method for assessinghedge effectiveness prospectively or retrospectively.

• The method an entity adopts depends on its riskmanagement strategy and should be included in the


management strategy and should be included in thedocumentation at the inception of the hedge.

• The most common methods used are:• critical terms comparison;• dollar offset method; and• regression analysis.


Effectiveness Test: Critical Comparison Test• Comparing the critical terms of the hedging instrument with those of the hedged

item.

• Hedge relationship is expected to be highly effective where all the principal termsof the hedging instrument and the hedged item match exactly – for example,


notional and principal amounts, credit risk (AA), term, pricing, re-pricing dates(aligned to test date), timing, quantum and currency of cash flows – and thereare no features (such as optionality) that would invalidate an assumption ofperfect effectiveness.

• Does not require any calculations.

• May only be used in the limited cases, but in such cases it is the simplest way todemonstrate that a hedge is expected to be highly effective (prospectiveeffectiveness testing).


• The dollar offset method can be performed using different approaches, including the following:

• Hypothetical derivative approach: The hedged risk is modelled as a derivative called a‘hypothetical derivative’ (as it does not exist). The hypothetical derivative approach compares thechange in the fair value or cash flows of the hedging instrument with the change in the fair value orcash flows of the hypothetical derivative.


• Benchmark rate approach: ‘target’ rate established for the hedge. In an interest rate hedge of avariable rate debt instrument using an interest rate swap, the benchmark rate is usually the fixedrate of the swap at the inception of the hedge. The benchmark rate approach first identifies thedifference between the actual cash flows of the hedging item and the benchmark rate. It thencompares the change in the amount or value of this difference with the change in the cash flow orfair value of the hedging instrument.

• Sensitivity analysis approach: assess the effectiveness of a hedge prospectively. This methodconsists of measuring the effect of a hypothetical shift in the underlying hedged risk (for example, a10% shift in the foreign currency exchange rate being hedged) on both the hedging instrument andthe hedged item.


• This statistical method investigates the strength of the statisticalrelationship between the hedged item and the hedging instrument.

• Provides a means of expressing, in a systematic fashion, the extent by


• Provides a means of expressing, in a systematic fashion, the extent bywhich one variable, ‘the dependent’, will vary with changes in anothervariable, ‘the independent’.

• The independent variable reflects the change in the value of thehedged item, and the dependent variable reflects the change in thevalue of the hedging instrument.


• IStaR Bank issues $100m of debt at a fixed interest rate e.g. at 8%. To avoid a mismatch betweenthe interest it pays for funding and the floating interest rate it receives on loans, the bank takes outan interest rate swap. The swap has the affect of IStaR paying a floating rate of interest on theissued debt, say at 11% instead of the 8% fixed (IStaR continues to pay fixed interest to the debtholders, but receives fixed interest from, and pays floating to, the swap counterparty)


IStaR assets with $ floating interest rates

IRS - IStaR pay $ floating interest to swap counterparty receives $ fixed

interest from swap

ASSETS LIABILITIES

• Impact on financials:

When the interest on debt increases leading to decrease in the carrying amount of thedebt by $10m. This has equal corresponding effect on notional amount of swap.

IStaR issued debt at a fixed rate @ 8%


Hedge Accounting Normal Accounting

BALANCE SHEET USD Mio USD Mio

Derivative Asset / (Liability) (13) (13)

Issued Debt (100) (100)

Fair value adjustment to Issued debt (increase) / decrease 10 Nil

Net issued debt Liability (90) (100)

P & L ACCOUNT


P & L ACCOUNT

Net Interest Income COUPON (8) (8)

SWAP ACCRUAL (3) 0

NET (11) (8)

Trading Income SWAP MTM (10) (13)

ISSUED DEBT FV ADJUSTMENT 10 NIL

NET PROFIT AND LOSS (11) (21)


Bank of Paris, has € 1 million of variable-rate demand deposit liabilities (DDL) at January 1 of Year 1. Based on priorexperience, Bank of Paris anticipates these customer accounts will remain outstanding for an average of three years. Thebank wishes to hedge its interest-rate exposure on these accounts by entering into an interest-rate swap. The swap has anotional amount of € 1 million and a term of three years, and net settlement in Euros is required on January 1 of each year,beginning with Year 2. Under the swap, Bank of Paris receives the London Interbank Offered Rate (LIBOR) plus 1% andpays a fixed rate of 4%. Thus, Bank of Paris will have an asset (a liability) position in the swap when the LIBOR plus 1% isgreater than (less than) 4%.


greater than (less than) 4%.

Assume the LIBOR rates, plus 1%, over the term of the swap are as follows:

– Year 1 (average and ending) 6%



For reporting purposes, Bank of Paris estimates the fair value of swaps by projecting future settlement amounts using thecurrent year’s variable rate and discounting these expected future cash flows for time value using the same variable rate.The relevant present-value interest factors are as follows:

– Present value of an annuity due of € 1 for 3 years at 6% 2.83339

– Present value of an annuity due of € 1 for 2 years at 3% 1.97087

Solution:

Cash flow hedge solution


Hedge accounting must be discontinued prospectively if:

– The hedging instrument expires or is sold, terminated or exercised


exercised

– The hedge no longer meets the IAS 39 criteria for hedge accounting (e.g. forecast transaction no longer highly probable)

– The entity revokes the designation


• Objectives

– Improvement of existing requirements as regards exposureand management of risks arising from financial instruments

– Removing unnecessarily onerous or duplicative disclosures


– Removing unnecessarily onerous or duplicative disclosures

– Relocating in one place all disclosure requirements onfinancial instruments

• Scope

– All risks arising from financial instruments

– All entities


Significance of financial

instruments for financial

position and performance

Classes of financial

instruments and level of

disclosure

Nature and extent of

risks arising from

financial instruments

IFRS 7


position and performancedisclosure financial instruments

Qualitative

disclosures

Other

disclosures

Income statement and equity

Quantitative

disclosures

Balance

sheet


Presenter’s contact details

CA Pooja Gupta

[email protected]


[email protected]

+91 – 9821504041

www.capoojagupta.blogspot.in

I F RS – I n t e r n a t i o n a l F i n a n c i a l R e p o r t i n g S t a n d a r d s

financial instruments ifrs 9 - wirc-icai

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