Under IFRS, a financial instrument has been defined as a contract that gives rise to a financial asset in one entity with a corresponding liability or equity in another entity. Most monetary items will get covered by this definition such as trade receivables/payables, investments in shares/debentures, retention money, trade deposits, derivatives, financial guarantees, and loans and advances.
Under the present Indian GAAP, Accounting Standard (‘AS’) 13 classifies an investment into long-term and current investment. Long-term investments are required to be recorded at cost, less any permanent diminution. Current investments are recorded at lower of cost or market. Detailed classification exists for banks as per RBI guidelines. Loans and receivables are stated at cost. Interest income on loans is recognised based on time-proportion basis as per the rates mentioned in the underlying loan agreement.
On the other hand under IFRS, all financial assets are required to be initially classified into four categories, comprising (i) fair value through profit or loss (FVTPL), (ii) held-to-maturity (HTM), (iii) loans and receivables, and (iv) available-for-sale (AFS). All financial assets will have to be recorded at respective fair values at the time of initial recognition.
Further, IAS-39 requires FVTPL and AFS assets to be measured at fair values at each subsequent reporting period. In case of FVTPL assets, the unrealised gain/loss is recognised in the profit and loss account whereas for AFS investments, it is recognised in equity until actually realised, whereupon it is transferred to the income statement. HTM and loans and receivable assets are reflected at amortised cost using effective interest method. However, the rules for classification of an investment as HTM are extremely stringent and any subsequent decision to sell these investments would result in adverse consequences, whereby all other existing HTM investments would need to be fair valued and there would be restrictions on future classifications.
Financial liability is classified into two categories, viz., (i) financial liability at fair value through profit or loss (ii) residual category. The initial measurement is at cost, being the fair value of a consideration received, less transaction costs. Financial liabilities at fair value through profit or loss (including trading) liabilities are measured at fair value, and the change is recognised in the income statement for the period. All other (non-trading) liabilities are carried at amortised cost. Entities may elect to classify certain liabilities as ‘fair value through profit and loss’ if the liabilities are incurred to hedge certain related financial assets which are required to be recorded at fair value. In such a case, a fair value designation for the liabilities can be used to set off the fair value changes in the assets — a form of economic hedge accounting, without following the complex hedge accounting designation and effectiveness testing rules.
Derivatives
The current Accounting Standards in India do not have any specific standard providing guidance on the recognition and valuation of derivatives. Accounting for certain plain vanilla foreign exchange forward contracts is based on AS-11. Certain exchange traded futures and options are accounted as per ‘Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options’. As per this Guidance Note, mark-to-market losses are recognised but gains are ignored. Further, some derivative instruments may be required to be accounted as per the March 2008 announcement of the ICAI, whereby derivative instruments are to be mark to market with the resulting losses required to be recognised in the income statement based on the principles of prudence. Effective 1 April 2011, the treatment for the aforesaid transactions will need to comply with AS-30 issued by the ICAI. As stated earlier, the guidance in AS-30 is consistent with the requirements of IAS-39.
IAS-39 deals with derivative instruments in a very comprehensive manner. A derivative is defined as a financial instrument or other contract with the following three characteristics, namely,
1) its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’);
2) it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
3) it is settled at a future date. Further all derivatives are recorded on balance sheet at fair value with changes in fair value being recognised in income statement unless it satisfies the hedge accounting criteria. This often results in significant volatility in reported income, which is not seen under the current Indian Accounting Standards.
Apart from stand-alone derivatives, IAS-39 requires derivatives embedded or contained in other contracts to be separated and accounted separately. For example, for convertible bonds an investor will have to account for the equity option component separately from the host debt contract. The value of the equity option component would be initially credited to equity. The resultant discount on the debt host would be amortised over the period of the debt to reflect the real cost of the debt instrument (based on market rates for non-convertible debt). Similarly, if an Indian entity has a contract for supply of goods/services denominated in Euros, with a counterparty based in a non-Euro zone country (for example, the U.S.), then there is an embedded rupee-Euro forward currency derivative, which will need to be separated from the host contract of supply of goods/ services and valued separately. The requirements for embedded derivatives will significantly enhance the valuation and measurement complexity of such instruments from current practice.
Hedge accounting
As seen above, IAS-39 uses a measurement model that sometimes requires the measurement of assets and liabilities on different basis. This results in an accounting mismatch in profit or loss account, which results in volatility in reported results (and does not reflect the true performance of the Company in the income statement). Consequently the standard permits an entity to selectively measure assets, liabilities, firm commitments and certain forecast transactions on a basis different from that prescribed, or to defer /match the recognition of gains or losses on derivatives using hedge accounting.
The hedge accounting rules under IFRS are quite stringent and narrowly defined. Hedge accounting is permitted if at the inception of the hedge and on an ongoing basis, the expectation is that the hedge will be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the of hedge is designated and ‘actual’ results are within the 80-125% range. If the changes don’t fall within this band, then the hedge is ineffective and, therefore, fair value gains/losses on the hedging contract will have to be taken to the income statement. Hedges need to be on specifically identified items as against portfolios and should hedge-specific risks and characteristics identified and documented upfront. Stringent documentation criteria prescribed shall also have to be followed.
Hedge accounting is voluntary and the decision to apply hedge accounting should be made on a transaction by transaction basis. The correct use of hedge accounting (for example, designating foreign currency forward contracts as cash flow hedges of forecasted foreign currency sales) can ensure that gains and losses relating to the derivatives are recorded to reflect the economic rationale for undertaking the transaction. In the absence of hedge accounting, gains and losses on derivatives would be recorded in periods that may be different from the periods in which the underlying transactions are recorded.
Substance over form
Under Indian GAAP, a financial instrument is v classified as either liability or equity, depending on form rather than substance.
Redeemable preference shares are treated as capital under Schedule VI of the Companies Act,1956, even though in substance it may be a liability. However, under IAS-32, they will get classified as debt in the balance sheet of the issuers, since they meet the characteristic of a liability, i.e., redemption after a fixed period and dividend at a fixed rate. This would result in profit after tax numbers being lower, as preference dividend would be reflected as interest cost. Further, premium on redemption of preference shares will no longer be able to be adjusted in the securities premium account but will have to be recognised as an interest expense in the income statement.
Another significant area of impact would be the accounting for Foreign Currency Convertible Bonds (‘FCCB’). FCCBs are bonds that can be converted into equity by the investors before a certain date, or are repaid at an agreed premium at the end of the tenure. FCCBs (and other debt instruments) may be issued with a structure that allows the borrower to pay the entire interest on the instrument (along with the principal) to the investor only when the bond matures, in the form of a ‘redemption premium’. The Companies Act, 1956, Section 78, permits companies to adjust the redemption premium on debentures just as in equity shares, through the share premium account. This accounting treatment is currently fairly common amongst many Indian companies. This accounting treatment would not be permitted under IFRS, as all cost of issuing an instrument (including the redemption premium) would need to be recorded as interest cost over the life of the debt using the effective interest yield method.
Further, under IFRS, FCCBs will be subjected to split accounting. In accordance with the guidance in IAS-39 on the basis of which the conversion option is separated from the host contract i.e., the debt liability depends on the characteristic of the conversion option. If the conversion option meets the definition of equity, then the fair value of the liability without the conversion option is first determined and the residual amount of proceeds is then allocated to equity. If the conversion option is a derivative (i.e., if the conversion price is determined in a currency other than the functional currency of the Company), the fair value of the derivative is first determined with the residual allocated to the debt amount and the derivative portion is fair valued at every reporting date.
Impairment
In the case of banks, the existing provisions on non-performing assets are based on guidelines laid down by the Reserve Bank of India. IFRS prescribes an impairment model that requires case-by-case (for significant exposures) assessment of the facts and circumstances surrounding the recoverability and timing of the future cash flows relating to the credit exposure. An expectation that all contractual cash flows would not be recovered (or recovered without full future interest applications) will lead to an account being classified as impaired and impairment shall be measured on present value basis using the effective interest rate of the exposure as the discount rate. For groups of loans that share homogenous characteristics (such as mortgage and credit card receivables), impairment can be assessed on a collective basis. General provisions are permissible only to extent that they relate to a specified risk that can be measured reliably and for incurred losses. No provisions are permitted for future or expected losses. Provisioning for standard assets will not be permitted under IFRS.
For investments, a similar analysis is conducted, the key difference being that the fair value of the investment is also considered as an input in addition to the financial! credit standing of the issuer. The application of IAS-39 would also change accounting for items such as financial guarantees. It will affect key ratios and performance indicators for most banks and financial institutions, including capital adequacy ratios.
De-recognition
Under IFRS, de-recognition of financial assets is a complex, multi-layered area with the de-recognition decision dependent largely on whether there has been a transfer of risks and rewards. If the assessment of the transfer of risks and rewards is not conclusive, an assessment of control and the extent of continuing involvement are required to be performed.
Securitisation transactions shall be the most impacted area since most Indian securitisation vehicles are currently structured to meet Indian GAAP de-recognition norms stated under the Guidance Note on Accounting for Securitisation issued byfhe ICAL Substantially, all those securitisation vehicles would collapse into the transferor’s balance sheet and assets would fail the de-recognition test under IFRS. For example, securitisation transactions where credit collaterals are provided/guarantee is provided to cover credit losses in excess of the losses inherent in the portfolio of assets securitised, may not meet the de-recognition principles enunciated in IAS-39. This would lead to more instances of transfers failing the de-recognition criteria, thereby resulting in large balance sheets and capital adequacy requirements, lower return on assets and deferral of gains/losses on such securitisation transactions.
Disclosures
IFRS 7 requires entities to provide detailed disclosures in their financial statements that enable users to evaluate:
a) the significance of financial instruments for the entity’s financial position and performance; and
b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks. On 5 March 2009, the IASB has issued Improving Disclosures about Financial Instruments (Amendments to IFRS 7). The amendments require enhanced disclosures about fair value measurements and liquidity risk.
The disclosures required under IFRS 7 include quantitative as well as qualitative information. There is a significant amendment in IT/reporting systems which shall be required as there is no accounting standard in India corresponding to IFRS 7 requiring such extensive disclosures. The Announcement on ‘Disclosure regarding Derivative Instruments’, issued by the ICAI, requires the following disclosures to be made in the financial statements:
a) categorywise quantitative data about derivative instruments that are outstanding at the balance . sheet date,
b) the purpose, i.e., hedging or speculation, for which such derivative instruments have been acquired, and
c) the foreign currency exposures that are not hedged by a derivative instrument or otherwise.
Netting assets and liabilities will also be less common as the rules will require more conditions to be met before assets and liabilities can be offset. A mere right to set off will not be adequate and needs to be supplemented with a right and an intention to settle on a net basis the assets and liabilities under consideration.
To conclude, the advent of IFRS shall thus represent a significant challenge to preparers, auditors, accountants, regulators and analysts. As the complexity of accounting increases, focus on need for increased education and training on areas relating to the valuation and accounting for financial instruments increases. Accounting for financial instruments will not only lead to a major impact on measurement of results, but also impact the existing functionalities of the IT systems and processes of companies.
