Accounting for financial instruments and derivatives – Part 2

Held to
maturity financial assets are non-derivatives with fixed or determinable
payments and fixed maturity that an entity has a positive intention and ability
to hold to maturity. These assets are initially recognised at fair value plus
transaction costs directly attributable to the transaction. They are
subsequently measured at amortised cost using the effective interest method and
are tested for impairment. The methodology of the computation of effective
interest method was discussed in Part One of this series of Articles.

The amount of
loss on impairment is measured as the difference between the carrying value and
the present value of expected future cash flows discounted at the effective
interest rate computed at the point of initial recognition. Such impairment can
be reversed in subsequent periods if it can be established that the event
leading to such reversal occurred after the date of recognition of the
impairment.

Merely because an
entity intends to hold the asset for an indefinite period, the asset cannot be
categorised as held to maturity. If the entity intends to sell the financial
asset as a result of changes in interest rates, risks, yields, liquidity needs,
foreign currency rates, then it cannot categorise the instrument as held to
maturity. If the issuer of the instrument has a right to settle the instrument
at a value significantly lower than its amortised cost, such an instrument
cannot be categorised as held to maturity.

An equity
instrument and perpetual debt instruments cannot be categorised as held to
maturity, as they do not have a fixed or determinable redemption date. Floating
interest rate instruments are not precluded from this classification so long as
they are not perpetual debt instruments. A default risk does not by itself
preclude this categorisation. If the instrument is callable by the issuer, the
instrument can be classified as held to maturity if at this point, the holder
can recover all or substantially all of the carrying value. If the callable
price is such that the holder cannot recover a substantial portion of the
carrying value, then such an instrument cannot be classified as held to
maturity. A puttable financial asset cannot be classified as held to maturity,
because a put feature is not consistent with intention to hold to maturity.

If the entity
transfers a held-to-maturity financial asset before maturity, the consequences
could be significantly adverse. The entity is required to reclassify its entire
held-to-maturity basket out of this basket immediately. Further, the entity is
not allowed to categorise any new financial asset as held to maturity in this
financial year and in the succeeding two financial years. Exceptions to this
treatment are few and include the following :

• Sale of the
  financial asset as a result of significant decline in creditworthiness of the
  issuer

• Changes in tax
  laws that may eliminate or reduce tax exempt status of such assets

• Major business
  combination or disposition that necessitates transfer of such assets to
  maintain the entity’s risk management or interest rate policies

• Changes in
  statutory or regulatory requirements including changes in risk weightages of
  such financial assets.

The entity’s
intention and ability to hold such financial assets to maturity are required to
be re-evaluated at each reporting date.

These are
non-derivative financial assets that are either designated as available for sale
or are not designated as any of the other three categories, viz. held at
fair value through profit and loss, loans & receivables or held to maturity.
They are measured at fair value plus transaction costs directly attributable to
the transaction on initial recognition. They are subsequently measured at fair
value without any adjustment for potential transaction costs on disposal.

However, if this
category includes any equity investments that do not have a quoted market price
in an active market and whose fair value cannot be reliably measured, then these
are measured at cost. This category of financial assets is subject to impairment
tests.

Gains and losses
on revaluation of available-for-sale financial assets are recognised in an
equity reserve account. These gains or losses are accumulated from period to
period in this account and recycled into the Profit and Loss Account on sale or
transfer of the financial asset. Dividends are recognised in the Profit and Loss
Account when the right to receive dividends is established. Interest income or
expense is recognised in the Profit and Loss Account based on effective interest
rate methodology. Impairment losses and foreign exchange gains or losses are
also recognised in the Profit and Loss Account.

Example :

Your entity
bought a G Sec for Rs.98 (Face value Rs.100, Tenor 7 years, Coupon 8% payable
annually in arrears). Let us assume for simplicity that this G Sec was bought on
day one of the accounting year. At the end of one year, the market price of this
G Sec is Rs.97.51. Your entity has categorised this G Sec as an
‘available-for-sale’ financial asset.

Let us examine
how this G Sec will be reflected in the financial statements.

The effective interest rate of the G Sec works out to 7.376%. The amortisation table for the G Sec is presented here:

The Profit and Loss Account of year one recognises an interest income of Rs.7.2285 as computed above. The difference between the carrying value as computed above (Rs.98.2285) and the market price (Rs.97.5100) is a loss of Rs.0.7185, which will be charged to reserves. The carrying value in the Balance Sheet will be Rs.97.51, which is arrived at after giving effect to interest income and mark to market impact.

Financial liabilities at fair value through profit and loss:

This category  would comprise    of :

One may wonder what kind of financial liabilities could be held for trading. A common example is short seiling of equity shares. The entity selling short would borrow securities from the market. The entity is now obliged to return back securities to the lender. The value of such securities would appear as financial liabilities in its Balance Sheet and would fluctuate with the price of the security.

On initial recognition, these financial liabilities are recognised at fair value. Transaction costs are charged to Profit and Loss Account. Subsequently, they continue to be carried in the Balance Sheet at fair value and gains/losses in fair value are recognised in the Profit and Loss Account. These liabilities are not tested for impairment.

Other financial  liabilities:

Financial liabilities other than those carried at fair value through profit and loss are categorised as ‘other financial liabilities’. They are initially recognised in the Balance Sheet at fair value minus transaction costs directly attributable to the transaction. They are subsequently carried at amortised cost in the Balance Sheet. Interest expense computed on effective interest rate method is recognised in the Profit and Loss Account.

When held to maturity securities are reclassified into Available-for-Sale category, the difference between the carrying amount (which would typically be computed on amortised cost) and the revised carrying amount (which would typically be fair value) would berecognised in reserves. As discussed earlier, if a significant quantum of held-to-maturity assets are sold or transferred or reclassified, the entire portfolio of such assets gets ‘tainted’ and is required to be reclassified into Available for Sale. The entity is not permitted to then classify any financial asset into held to maturity basket for that financial year and the succeeding two financial years.

Where a financial asset is classified into the held to maturity category, the carrying amount on the day of reclassification is recognised as its amortised cost. In case of a financial asset with fixed maturity any amount that has been previously recognised in reserves is required to be amortised over the balance time to maturity using effective interest rate method. If the asset does not have a fixed maturity, the amount previously recognised in reserves will remain in reserves till disposal of the asset.’

De-recognition of financial assets:

The entity is required to de-recognise a financial asset when the contractual rights to the cash flows from the financial asset expire. In the world of securitisation, transfers of financial assets involve complex conditionalities and the standard deals with such complexities in an elaborate manner. These are not discussed in this Article.

On de-recognition of an asset, the difference between its carrying amount and the sum of (a) the consideration received and (b) the amount recognised in a reserve account till date should be recognised in the Profit and Loss Account.

Example:

Your entity bought an equity share of L&T for Rs.3,200. This was revalued at the last quarter end at Rs.l,OOO.The investment revaluation reserve carries a debit balance of Rs.2,200 being the cumulative impact of revaluations from the date of purchase to the last quarter end. The entity now sells this share for Rs. 1,025 (ignoring transaction costs).

The profit and loss account will recognise a loss of Rs.2,175. This comprises a gain of Rs.25 (difference between carrying amount of Rs. 1000 and consideration of Rs.l,025) and the cumulative previously recognised losses of Rs.2,200 in reserves, which are now recycled into the Profit and Loss Account.

There appears to be no bar on such an investment revaluation reserve carrying a debit balance as per paragraph 61(b) of AS-30.

De-recognition of financial liabilities:

Financial liabilities’ are de-recognised when the liability is extinguished, that is when the obligation in the contract is discharged or cancelled or expires. An exchange between a borrower and a lender of financial instruments substantially different from existing instruments should be treated as an extinguishment of the earlier liability and a new liability should be recognised.

The difference between the carrying amount and the consideration paid, including any non-cash assets transferred or liabilities assumed, should be recognised in the Profit and Loss Account.