Day one fair valuation of financial instruments

This article illustrates the accounting implications of day one fair valuation of assets and liabilities on initial recognition and its subsequent measurement. When a financial asset or financial liability is recognised initially in the balance sheet, the asset or liability is measured at fair value (plus transaction costs in some cases). Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction.

In other words, fair value is an actual or estimated transaction price on the reporting date for a transaction taking place between unrelated parties that have adequate information about the asset or liability being measured.

The following are certain transactions where fair value on initial recognition may be different than their transacted amounts.

1. Low-interest or interest-free loans Where a loan or a receivable is transacted at market interest rates the fair value of the loan will equal the transaction value. If a loan or a receivable is not based upon market terms, then it is accounted for in accordance with IAS 39 which states that “the fair value of a long-term loan or receivable that carries no interest can be estimated as the present value of all future cash receipts discounted using the prevailing market rate(s) of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any additional amount lent is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.” In assessing whether the interest charged on a loan is below market rates, consideration should be given to the following factors:

In particular, the entity would consider the interest rates currently charged by the entity or by others for loans with similar maturities, cash flow patterns, currency, credit risk, collateral and interest basis.

Initial recognition

A. Repayable on demand: A loan repayable on demand is not required to be discounted, as the fair value of the cash flows associated with the loan is the face value of the loan (due to it being repayable on demand).

B. Repayable with fixed maturity: The fair value of the interest-free loan is the present value of all future cash flows discounted using the market-related rate over the term of the loan. The rate used to discount an interest-free loan is the prevailing market interest rate of a similar loan. Any difference between the cost and the fair value of the instrument upon initial recognition is recognised as a gain or a loss, unless it qualifies to be recognised as an asset or liability. Subsequent measurement If the loan is classified by the lender as a ‘loan and receivable’, the loan is measured at amortised cost using the effective interest rate method. The fair value of the loan will increase over the term to the ultimate maturity amount. This accretion will be recognised in the income statement as interest income.

 For the borrower that measures the financial liability at amortised cost, the liability will increase over the life of the loan to the ultimate maturity amount. This accretion in the liability will be recognised in the income statement as interest expense. Illustration — Nil interest loan between common control parties When low-interest or interest-free loans are granted to subsidiaries, in the separate financial statements of the investor, the discount should be recognised as an additional investment in the subsidiary. In the separate financial statements of the investee, the effect would be given in the shareholders’ equity. Illustrative examples

Assume the face value of the loan is Rs.100,000 and the fair value of the loan is Rs.80,000 at the initial recognition date.

Case 1: Parent grants interest-free loan to the subsidiary

Case 2: Subsidiary grants an interest-free loan to its parent

Case3: Subsidiary grants an interest-free loan to another fellow subsidiary

Note: Deferred tax entries have been ignored

2. Low-interest or interest-free loans to employees

Loans given to employees at lower than market interest rates generally are short-term employee benefits. Loans granted to employees are financial instruments within the scope of IAS 39 Financial Instruments. Therefore, low-interest loans to employees should be measured at the present value of the anticipated future cash flows discounted using a market interest rate. Any difference between the fair value of the loan and the amount advanced is an employee benefit. If the favourable loan terms are not dependent on continued employment, then there should be a rebuttable presumption that the interest benefit relates to past services, and the cost should be recognised in profit or loss immediately. If the benefit relates to services to be rendered in future periods (e.g., if the interest benefit will be forfeited if the employee leaves, or is a bonus for future services), then the amount of the discount may be treated as a prepayment and expensed in the period in which the services are rendered. If the services will be rendered more than 12 months into the future, then the entire benefit is a long-term benefit.

The above accounting treatment would not hold good if the loans are repayable on demand. This is because in absence of a fixed tenure and the feature of repayable on demand, the fair value of the loan would correspond with the amount of the loan.

3.    Interest-free security/lease deposits

Initial recognition

In case of the provider of the deposit, the deposit should be recognised at fair value. The difference between the fair value and transaction amount would be considered as a prepaid rent under IAS 17 for the provider.

Subsequent measurementThe loan is classified by the provider of the deposit as a ‘loan and receivable’; the loan is measured at amortised cost using the effective interest rate method. The fair value of the deposit will increase over the term to the ultimate maturity amount. This accretion will be recognised in the income statement as interest income and prepaid rent will be amortised on a straight-line basis as rent expense under the principles enunciated in IAS 17.

For the receiver of the deposit, the deposit shall be classified as a financial liability at amortised cost; the liability will increase over the life of the loan to the ultimate maturity amount. This accretion in the liability will be recognised in the income statement as interest expense and advance rent received will be amortised on a straight-line basis as rent income. The amortisation would be similar to the prepaid salary as illustrated above.

Illustration

Assume Rs.1,000,000 lease deposit has been given — interest-free for a term of 5 years. Assuming market rate of borrowing is 10% for the lessee and market rate for investments is also 10% for the lessor. The fair value on the first day of the lease would be Rs.620,931 (i.e., fair value as discounted).

The accounting would be as follows:

The aforesaid accounting principles would not apply if the lease is a cancellable lease, since then the security deposit would be repayable on demand and as explained above would need to be accounted at the transaction value.