financial instruments ifrs 7 ias 32 ias 39 by dr.anjali bhave

FINANCIAL INSTRUMENTS

• IFRS 7

• IAS 32

• IAS 39

by• Dr.Anjali Bhave

Financial instruments background

• Increased complexity of financial instruments

• Harmonised global markets

• Concept of fair value

Financial instruments background

Need for better disclosures and assessment of risks

Unprecedented global financial crisis

Governance issues

What is included in the standards?

• IAS 39

– Recognition and derecognition of financial instruments

– Measurement of financial instruments

– Derivatives and hedge accounting

What is included in the standards?

• IAS 32

Presentation of financial instruments - Debt and Equity classification

• IFRS 7

Financial instruments disclosures

What is a Financial instrument?

• Contract giving rise to

• Financial asset of one entity

and

• Financial liability / equity of another entity

Financial asset

Any asset that is• (a) Cash;• (b) An equity instrument of another entity;• (c) A contractual right to receive cash or

another financial asset from another entity or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity or

Financial asset

• (d) A contract that may or will be settled in the entity’s own equity instrument and is – 1) a derivative which will or may be settled

other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments

– 2) non derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or

Financial liability

Any liability that is

• a) A contractual obligation

1) to deliver cash or another financial asset to another entity or

2) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity

Financial liability

b) A contract that will or may be settled in the entity’s own equity instruments– 1) a derivative which will or may be settled

other than by exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments

– 1) non derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments or

Examples

• Financial assets

– Cash – Investment in shares– Receivables– Loans to other entities– Investments in bonds and other debt instruments

• Financial liabilities

– Trade payables– Loans from other entities– Bonds and other debt instruments issued

Categories of Financial assets – IAS 39

• Financial assets held for trading

• Held-to-maturity investments

• Loans and receivables

• Available-for-sale financial assets

Categories of Financial assets – IAS 39

Financial assets at fair value through profit or loss – Designated as such upon initial recognition

– Those classified as held for trading

– Derivatives not accounted for as hedges

Classification as held for trading

Acquired or incurred principally for the purpose of selling or repurchasing it in the near term

Part of a portfolio of identified financial instruments with evidence of a recent actual pattern of short-term profit-taking

Classification as held for trading

A non hedging derivative

• An entity may also designate an entire hybrid contract at fair value through profit or loss if the contract contains one or more embedded derivatives

Categories of Financial assets – IAS 39

Held-to-maturity investments - financial assets

With fixed or determinable payments and fixed maturity (eg, debt securities and redeemable preference shares)

That an entity has the positive intent and ability to hold to maturity.

Categories of Financial assets – IAS 39

Loans and receivables

Non-derivative financial assets with fixed or determinable payments not quoted in an active market

Arise when entity provides money, goods or services directly to a debtor with no intention of trading the receivables

.

Categories of Financial assets – IAS 39

Available-for-sale financial assets

Residual category –

assets that are not classified in another category

FINANCIAL INSTRUMENTS – DECISION TREE FOR CATEGORIES

•

•

Asset is acquired/held to generate profit? Or originated to be sold in the short-term?

NO

Part of portfolio with a pattern of profit taking?

NO

Is it a derivative?

Are there: -fixed and determinable payments -fixed maturity - intent & ability to hold maturity?

NO

NO

Is it created by giving money, goods or services directly to debtor?

Available for sale

NO

Held to maturity

YES

YES

YES

YES

Is its designated & effective hedge

NO

Apply hedge accounting

YES

Is there intention to sell in theshort term?

YES

Financial assets at fair value through P&L

Loans and receivables

NOYES

Categories of financial liabilities – IAS 39

Financial liabilities at fair value through profit or loss

– designated as such upon initial recognition and

classified as held for trading

– Derivatives unless accounted for as hedges

Categories of financial liabilities – IAS 39

Financial liabilities measured at amortised cost

Residual category –

Liabilities that are not classified in another category

Derivatives

Financial instruments with following characteristics:

Value changes in response to changes in an ‘underlying’ price or index

Requires no initial net investment or an initial net investment that is smaller than would be required to purchase the underlying instrument

Settled at a future date.

Recognition and Initial measurement

All financial assets and liabilities need to be recognised

At fair value

When the entity becomes party to the contractual provisions of the instrument

Fair value

Amount for which an asset could be exchanged or liability settled

Between knowledgeable willing parties

In an arm’s length transaction

Example of fair value of a debt instrument

classified as HTM Loan given to a vendor Rs 10000

For a period of 5 years,

Carries interest at a rate of 5% (payable annually)

Interest rate for similar loans from the market is 10%.

The loan’s fair value is calculated as a net present value of

interest payments

and principal repayments

discounted at 10% is 8,105

Subsequent measurement

INSTRUMENT Financial assets at fair value through profit or loss

MEASUREMENT Fair Value

VALUE CHANGES P&L

Subsequent measurement

INSTRUMENT Held-to-maturity investments

• MEASUREMENTA mAmortised cost effective interest ratertised cost

• (effective interest rate)

• VALUE CHANGES Not relevant(unless impaired)

Subsequent measurement

INSTRUMENT Loans and receivables

MEASUREMENTA mAmortised cost

(effective interest rate)rtised cost• (effective interest rate)

VALUE CHANGES Not relevant

(unless impaired)

Subsequent measurement

INSTRUMENT Available-for-sale

MEASUREMENTA cFair Valuest

• (effective interest rate)

VALUE CHANGES Equity

IAS 32 DEBT EQUITY CLASSIFICATION

Classification - substance of a financial instrument rather than its legal form

Debt - Contractual obligation to deliver cash or another financial asset under conditions that are potentially unfavourable

Equity - Exposure to the risk of fluctuations in price or residual interest of issuer’s equity

FINANCIAL INSTRUMENTS –DEBT EQUITY CLASSIFICATION

• :

Yes

Yes

No

Is settlement in cash either:-mandatory-at the option of the holder

Does the settlement depend on the outcome of uncertain future events or circumstances beyond the issuing undertaking’s control?

In substance, does the issuing undertaking have full discretion to avoid cash settlement?

Is the possibility that the issuing undertaking will be required to settle in cash/other financial asset remote?

Is settlement in a variable number of the issuing undertaking’s equity securities?

Is the holder exposed to the risk of fluctuations in (a)price or (b)(b)residual price or (b) residual interest in the issuing undertaking's own equity securities?

EQUITY LIABILITY

Yes

Yes

No

Yes

NoNo

No

No

Yes

IAS 32 DEBT EQUITY CLASSIFICATION

• A financial instrument is

– a liability if it is a contractual obligation to deliver cash or other financial assets

- equity if it evidences a residual interest in the assets of an undertaking after deducting all of its liabilities.

IAS 32 DEBT EQUITY CLASSIFICATION

• Convertible debt that gives the holder choice of repayment in cash or in shares -- separated into its debt and equity components.

• Analysed into an issue of ordinary debt at a discount, and a credit to equity for the conversion right.

IAS 32 DEBT EQUITY CLASSIFICATION

• A convertible bond issued @ Rs 100 carrying 6% interest p.a,

• Convertible in 25 equity shares after 3 years• Bond without convertible feature carry interest

@ 9%.• Value of debt = PV of interest payments + PV of

principal @ 9% = 5.5+5.05+4.63+77.22 =92.4• Value of equity = 100- 92.4 = 7.6

IAS 32 Convertible instruments

Fixed for fixed principle

Contract to exchange a financial asset for an entity’s own equity instruments is classified as equity only if

• the amount of financial assets

And

• the number of equity instruments are fixed.

IAS 32 FCCB

If the amount is fixed but in a currency other than the functional currency of the issuing entity, then the amount is not fixed for the purpose of classifying the financial instrument

FCCBs to be accounted for as liability at fair value through profit and loss.

Reclassification

• Trading Not permitted

• Loans and receivables Trading - If pattern of short term profit making

• Held-to-maturity Trading / Available for sale - Tainting

Reclassification

• Available for sale Trading - If pattern of short term profit making

Held to

Maturity Change in intent and if all criteria met

Amortisation

Calculated using the effective interest rate method

= the rate that exactly discounts estimated future cash flows through the expected life of the financial instrument

IRR

Amortisation

• To continue the previous example

• Value of debt = 92.4

• Cost of issue 1%

• Net proceeds 92.4-.92 = 91.48

• The rate that equates this inflow with outflows of 6,6,106 is 9.38%

• This rate is called effective interest rate and used for amortisation

Amortisation

Opening balance

Interest @9.38%

Cash paid Closing

liability

91.48 8.58 6 9.48

94.06 8.82 6 96.88

96.88 9.09 6 99.97 / 100

Derecognition

Derecognition is removal of an asset or liability from the balance sheet

The standard combines the ‘risk and rewards approach’ and ‘control approach

Derecognition

• A financial liability is removed from the balance sheet only when it is extinguished –that is when the obligation specified in the contract is discharged or cancelled, or expires

• A transaction is accounted for as a collateralised borrowing if the transfer does not satisfy the conditions for derecognition

Derecognition

When

The rights to the cash flows from the asset expire

The rights to the cash flows from the asset and substantially all risks and rewards of ownership of the asset are transferred

Derecognition

• An obligation to transfer the cash flows from the asset is assumed and substantially all risks and rewards are transferred

• Substantially all the risks and rewards are neither transferred nor retained but control of the asset is transferred.

Derecognition

If the undertaking retains control of the asset but does not retain or transfer substantially all the risks and rewards

The asset is recognised to the extent of the undertaking’s continuing involvement.

Derecognition

If an undertaking has neither transferred nor retained substantially all the risks and rewards of ownership of the transferred asset

Then

It assesses whether it has retained control over the transferred asset.

Derecognition

If the undertaking has retained control

It continues to recognise the transferred asset to the extent of its continuing involvement in the transferred asset

If it has not retained control it derecognises the transferred asset.

Derecognition SPEs etc

Many derecognition structures use • undertakings (trusts, partnerships, etc.) that

have been specifically set up for the acquisition of the transferred assets.

• The transfer of assets may qualify as a legal sale

• If the transferor controls the transferee, the transferor needs to consolidate the transferee.

Derecognition sequence

• Consolidate all subsidiaries (including all SPEs)– Derecognition provisions are applied on a

consolidated level

• Consider the subject of the derecognition provisions (financial asset, group of similar financial assets or a portion of a financial instruments or a group of similar financial instruments)

• Apply derecognition rules

DECISION TREE FOR DERECOGNITION OF ASSETS

Derecognition

• Financial liability (or part thereof) is removed from the balance sheet when it is extinguished

• when the obligation is

• discharged or

• cancelled or

• expires

IFRS 7 Disclosures

• Qualitative description

• Quantitative data

• Level of information

Overburdening vis a vis obscuring due to aggregation

IFRS 7 Disclosures

• Objectives

– Information about FAs & their impact on financial performance

– Assessment of risk and how it is managed

IFRS 7 Disclosures

• Disclosures relate to the following risks

• Credit risk

• Liquidity risk and

• Market risk

IFRS 7 Disclosures

The disclosures shall be either

• In the financial statements or• Incorporated by cross-reference from the

financial statements to some other statement, such as a management commentary or risk report

• Available to users on the same terms as the financial statements and at the same time.

Qualitative disclosures

For each type of risk, an undertaking shall disclose

(i) the exposures to risk and how they arise(ii) its objectives, policies and processes for

managing the risk and the methods used to measure the risk and

any changes in (i) or (ii) from the previous period

Qualitative disclosures

• Credit quality disclosures

– about the credit quality of financial assets that are neither past due nor impaired

– For ex - the amounts of credit exposures for each external credit grade

• - the rating agencies used; • - the amount of an entity’s rated and unrated

credit exposures

Qualitative disclosures

Market risks

Open positions in interest rate, currency and equity products, all of which are exposed to general and specific market movements.

Quantitative disclosures

For each type of risk, an undertaking shall disclose

Summary quantitative data about its exposure to that risk at the reporting date.

Based on the information provided to key management, such as the board of directors or chief executive officer.

Disclosure of concentrations of risk

From financial instruments that have

• Similar characteristics and

• Affected similarly by changes in economic or other conditions.

Requires judgement reflecting the circumstances of the undertaking.

Disclosure of concentrations of risk

Includes

• how management determines concentrations;• the shared characteristic that identifies each

concentration (eg counterparty, geographical area, currency or market)

• the amount of the risk exposure associated with all financial instruments sharing that characteristic

Disclosure of concentrations of risk

Concentrations of assets, liabilities and off-balance sheet items

GeographicalCurrency Industry Market Type of counterparty

Credit risk - disclosures

Failure to pay by a counterparty causing financial loss

• Maximum credit exposure for each class of FI.

• Collateral and other credit enhancements obtained

Credit risk - disclosures

• The amount that best represents its maximum exposure to credit risk at the reporting date, without deducting any collateral held or other credit enhancements (such as netting agreements that do not qualify for offset – see IAS 32)

• In respect of the amount disclosed in (i), a description of collateral held as security and other credit enhancements;

Credit risk - disclosures

• Information about the credit quality of financial assets that are neither past due nor impaired and

• The carrying amount of financial assets that would otherwise be past due or impaired whose terms have been renegotiated

Credit risk - disclosures

• Past due / impaired

• Age analysis

• Analysis of asset

• Description and Fair value of collateral

Liquidity risk

An undertaking shall disclose

(i) a maturity analysis for financial liabilities (owed by the undertaking) that shows the remaining contractual maturities and

(ii) a description of how it manages the liquidity risk inherent in (i).

Market risk

• Sensitivity analysis

• A sensitivity analysis is needed for each type of market risk to which the entity is exposed.

• A sensitivity analysis is disclosed for each currency to which an undertaking has material exposure.

Sensitivity analysis

• Not to include worst case or stress test situations

• Methods like VaR

( A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities)

IFRS 7

• Usefulness?

• Voluminous

• Subjectivity

• Lack of comparability

THANK YOU

Dr.Anjali Bhave

arbhave@gmail.com

9322249029