overview of as 30 financial inst. & derivatives. flow of presentation overview of as 30...
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Overview of AS 30 Financial Inst. & Derivatives
Flow of presentation
Overview of AS 30 Derivatives Financial Instruments Hedge Accounting Key Challenges
Overview – Scope & Principal Objective
Main objective is to establish principles for recognising and measuring financial instruments whose definition encompass most items of financial assets, financial liabilities in an entity's balance sheet
Derivatives and hedge accounting.
Derivatives : Thumb Rule
Examples of Underlying
Credit Rating
Other Variable
Interest Rates
Commodity Prices
Foreign Exchange rate
Indices
Thumb Rule : Underlying is any vaiable whose changes are observable or otherwise objectively verifiable
Underlying Examples
Derivatives -definition
Three characteristics
Fair value changes in response to the change in
underlying
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 chnages in market factors
Settled at a future date
Types Of Derivatives
Futures
Swaps
Der
ivat
ives
OptionsForward Rate Agreement
Forward Contracts
Embedded derivatives An embedded derivative is a Component of a hybrid instrument that also includes a non –derivative host contract
Bond which is convertible into equity Hybrid contract- Convertible bond
Host contract – Bond Asset Embedded Derivative-Conversion option
Lease agreement with inflation factor Hybrid Contract- Entire Lease Host Contract- Lease contract Embedded derivative- Adjustment for the inflation
Indian Entity A sells furniture to Indian Entity B in USD
Accounting for derivative contracts
The default accounting treatment for all derivative contract is
They are recorded on the balance sheet at fair value
Change in Fair value are recognized in the income statement.
Leads to unprecedented levels of P&L statement volatility.
Derivatives excluded from AS30 derivatives accounting rules
Contracts for ‘normal’ purchases and sales of non-financial items
Intended to meet purchases, sales or usage requirements
Designated for that purpose
Will be settled by delivery
Regular way purchases or sale of a financial assets
Delivery within a time frame established by regulation or convention in the market.
Apply trade date or settlement date accounting.
Financial Instruments
Definition:- A financial instrument is any contract that give rise to both:
(a) a financial assets of one entity and (b) a financial liability or equity instrument of another entity.
Sr. No. Assets Classifications
1 Investment in Equity Share Financial Assets
2 Trade & other Receivable Financial Assets
3 Cash & Cash Equivalents Financial Assets
4 Inventories Not a Financial Instrument
5 Income Taxes Not a Financial Instrument
6 Gold Not a Financial Instrument
Financial assets classification
Financial asset at fair value through profit and loss
Held to maturity Investment
Loans and receivables
Available for sale.
Restrictions on reclassification between categories except exceptional circumstances.
Financial assets classification-Cont
TradingHeld for Purpose of
Short term Profit
Originated by the enterprise ?
Loans and receivable originated
Intent and ability to hold to maturity?
Available for- sale
Held to Maturity
YesYes
NO
NO
YES
Yes
NO
NO
YES
Financial Instrument- Fair value & Accounting
XYZ Ltd Issue At Par 6 % debenture @1000/- each convertiable at the end of three yearDate Particulars Amount Rate Remarks
Year 1 Convrtiable Debenture 20 Lacs 6% 2000, 3 year Term issud at PAR
Market Rate for similar 9%debt without conv option
How to recognise Fair Value of Liabiliy & Equity Portions ??
Financial Instrument- Fair value & Accounting
Rs LacsParticulars Amt
Present Value of the Prinnciple - 20 lacs payable at the end of 3 years15.5
Present Value of Interest- Rs 1.20 lacs per annum 3.04
Total Liability Component 18.5
Net proceeds from the debenture issue 20
Net Difference towards equity component 1.51
Year Prn. O/s Interest@9% 6% paid Principle O/s closing
1 18.5 1.7 1.2 19.0
2 19.0 1.7 1.2 19.5
3 19.5 1.7 1.2 20.0
Conversion take place at end of 2nd year ??
Redemption take place at the end of 3rd year ??
Introduction –Concept of Hedging
Why 'Hedging' ?
A perfect hedge reduces investor's risk to nothing except for cost of the hedge.
Types of hedges
Fair Value hedges Hedge of exposure to changes in fair value of: - a recognized asset or liability; an unrecognised firm commitment; or an identified
portion of any of the above two; - that is attributable to a particular risk; and
- could affect P & L
Cash flow hedges Hedge of exposure to variability in cash flows that is - attributable to a particular risk associated with a recognized assets or liability or a
highly probable forecast transaction ( also an inter-company one) and
- could affect P & L
Hedge of Net investment in a foreign operation
Fair Value hedge accounting model
Measurement of hedge item
Fair Value
Fair Value with respect to risk being hedged
P & L
Changes in FVMeasurement of Derivaitves instrument
Cash flow hedge accounting model
Measurement of Derivative Instrument Changes in FV
Fair Value Equity
P & L
E ffective
Application of Hedge Accounting
Whether hedging instrument isa “ Qualified Instrument” ?
Whether “ Hedge Relationship”Is established ?
Does it Pass the “ Hedge Effectiveness” test ?
Apply hedge accounting
Adjust MTM in P/L Account
NO
NO
NO
NO
Cash Flow Hedge- AccountingImporter A Ltd hedge the forecasted import purchase cash flow through forward contract as per detail given below :
Date Particulars Amount(FC) Rate Remarks
20.06.07 Pur. contract 100000 Delivery March 08 & Due June 08
30.06.07 Fwd contract 100000 1.096 Cash flow hedged for June 08
Date Spot Rate Fwd Rate June 08 Fair Value30.06.07 1.072 1.096 031.12.07 1.08 1.092 (400) 31.03.08 1.074 1.076 (2,000) 30.06.08 1.072 1.072 (2,400)
Cash Flow Hedge- AccountingDate Particulars Debit Credit Remarks
30.06.07 No Change in fair value
31.12.07 Equity A/c 400 Being Loss on forward contract Forward Liability 400 parked in equity account
31.03.08 Equity A/c 1600 Being Loss on forward contract Forward Liability 1600 parked in equity account
31.03.08 Purchase A/c 107400 Being purchase recorded at spot Payable 107400 rate on 31.03.2008
31.03.08 Purchase A/c 2000 Being cuulative loss on fwd Equity A/c 2000 contract recognised in P&L A/c
30.06.08 Payable A/c 107400 Being settlement of payable at Bank A/c 107200 spot rateProfit & Loss A/c 200
30.06.08 P&L A/c 400 Being loss accountd on fwd Forward Liabiliy 400 contract
30.06.08 Forward Liabiliy 2,400 Being forward contract settledBank A/c 2,400
Cash Flow Hedge- AccountingHedge- Effectiveness??
Assuming actual purchase take place on 20th June 2008
Particulars 30.06.07 31.12.07 31.03.08 30.06.08
Spot Rate 1.072 1.080 1.074 1.072
Forward rate- 30 th June 08
1.096 1.092 1.076 1.072
Forward rate- 20 th June 08
1.091 1.086 1.070 1.068
FV of forward Contract
- (400) (2,000) (2,400)
FV of Cash flows (Purchase)
- 500 2,150 2,350
Effectiveness 80% 93% 102%
Evaluate whether the above hedging relationship is highly effective at the end of each period.
Hedge Accounting strict Criteria
Hedged Item and
Hedgeable Risks
Assesing effectiveness &
measuring
Hedging Instrument
Formal Documentation
Criteria for hedge accounting – documentation Hedge Relationship must be documented at inception
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 relationship must be expected to be highly effective at inception and subsequent periods
Hedge effectiveness can be reliably measured
Actual Hedge effectiveness must be measured
In the case of hedging future cash flows, there must be a high probability of the case flow occurring
Hedging anticipated future cash flows is more difficult under AS 30
In the case of hedging future cash flows, there must be a high probability of that cash flow occurring
• Exposure to Variability in cash flows
- capex, floating interest rate, commitments and anticipated exposure
• High probability test to be satisfied on cash flow exposure
- Generally more than 90% probability
Scale of Probability of the forecasted transaction.
Special Rule: Cumulative gain and loss on hedging instrument remains in equity “ freeze mode” if test satisfied in a prior period
Hedge Accounting
Not Occuring Highly ProbableExpected to Occur
Firm Commitment
Hedge Effectiveness
Hedge Relationship must be expected to be highly effective at inception andIn subsequent periods
• General Principles
• Hedge effectiveness criteria
- highly effective at inception
- satisfy 80-125% effectiveness back test
Hedge accounting ineffectiveness in P&L
Hedge accounting ineffectiveness in P&L
125%
100%
80%
• Different notional and principal Amount for the derivatives And hedged item• Different maturity and re-set Dates• Currency differences• Credit Differences• Inclusion of Time Value
When a hedge no longer is effective
If the ongoing highly effective criterion fails, hedge accounting is discontinued.
- Hedge activity recorded prior to loss of effectiveness is not affected.
- The hedge does not qualify for special accounting prospectively from the last time it was proven effective.
- There is therefore a trade off between performing effectiveness testing frequently to ensure effectiveness and the administration effort into doing this frequently.
Hedge of a Net Investment in a Foreign Operation- Accounting Model
Measurement of Hedging Instrument
Measurement of Net Investment
Fx Transaction gains & Losses
Equity
Fx Transaction gains & Losses
Effective Portion
Special treatment for hedge accounting
Challenges :
Change in accounting ushered in by the standard can substantially affect the operation of entities
potential to accentuate earnings volatility especially since hedge accounting has been defined very rigorously
fair value measurement would pose a serious challenge in the valuation of financial instruments
need to revamp the MIS and technology capabilities of the entities that have to comply with AS 30 for which significant initial investment would have to be earmarked