Financial Instruments
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Financial Instruments

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contains basic of financial instruments as per IFRS

contains basic of financial instruments as per IFRS

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Financial Instruments Financial Instruments Presentation Transcript

  • Welcome to the Management Development Programme on Accounting for Financial Instruments
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity• Financial Guarantee
  • Accounting for Financial InstrumentsSession 2 Financial Assets & Financial Liabilities [ 11.00 – 12.00 hrs]• Classification of financial assets and financial liabilities• Measurement of financial assets and liabilities at initial recognition and subsequent measurement• Fair value measurement issues• Amortised cost accounting• Reclassification• Derecognition
  • Accounting for Financial Instruments• Session 3 : Compound financial Instruments & Embedded Derivatives [ 12.00-13.00 hrs]• Separation of Convertible Debentures• Separation of embedded derivatives
  • Accounting for Financial Instruments• Session 4 Hedge Accounting[ 14.00 – 15.30 hrs & 15.45- 17.00 hrs]Hedged itemHedging InstrumentsHedging relationshipsFair value hedge , cash flow hedge and hedgingnet investment in foreign operations
  • Accounting for Financial Instruments• Session 5 : Financial Instruments : Disclosures[ 17.00- 17.30 hrs]
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity
  • Introduction of financial Instrument standards• Financial instruments standards evolved through a sustained effort of the International Accounting Standards Committee ( the IASC), the predecessor of the International Accounting Standards Board ( the IASB) which began a project, jointly with the Canadian Institute of Chartered Accountants ( CICA) , to develop a comprehensive Standard on the recognition, measurement, and disclosure of financial instruments.• The process began with the issuance of Exposure Draft E40 Financial Instruments issued in September 1991.
  • Emergence of IAS 32• Standards on financial instruments were developed in different phases . The IASC (the predecessor of the IASB) approved IAS 32 Financial Instruments : Presentation and Disclosures in 1995.• In August 2005, the IASB expanded the disclosure aspects of IAS 32 by issuing a separate International Financial Reporting Standard 7 (IFRS 7) Financial Instruments: Disclosures. Consequently, the title of IAS 32 was changed to Financial Instruments: Presentation.
  • Emergence of IAS 39• IAS 39 was issued in December , 1998 which became effective for annual periods beginning on or after 1 January, 2001.• The International Accounting Standards Board (IASB) succeeded the IASC in 2001. In 2002, in response to practice issues identified by audit firms, national standard- setters, regulators and others, and issues identified in the IAS 39 implementation guidance process, the IASB proposed changes to both IAS 32 and IAS 39. It issued revised versions of both the standards in December 2003.
  • IAS 39 Implementation Guidance• In July 2001, Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance was issued to assist financial statement preparers, auditors, financial analysts, and others to understand IAS 39, and to ensure consistent application of the Standard.
  • Project to Replace IAS 39• The IASB intends to replace IAS 39 in phases by IFRS 9 . IAS 39 replacement project was adopted out of its joint project with FASB “ Reducing Complexity in Reporting Financial Instruments” ( March 2008) , and noted deficiencies of IAS 39 to cope with the scenarios arising out of economic recession. The replacement project is dividend into three phases –• Phase 1: Classification and measurement of financial assets and financial liabilities• This phase had been completed in 2010. IFRS 9 contains the outcome of this phase.• Phase 2: Impairment methodology ( work-in-progress)• Phase 3: Hedge accounting ( work-in-progress).• The latest version of IAS 39 only contains impairment and hedge accounting.
  • Emergence of IFRS 9• On 12 November 2009, the IASB published IFRS 9 Financial Instruments which covers the classification and measurement of financial assets. The Board finalised this phase in time to allow, but not require, early application for 2009 year-end financial statements.• In October 2010, requirements relating to the classification and measurement of financial liabilities were included to IFRS 9.• This includes requirements on embedded derivatives and how to account for own credit risks for financial liabilities that are measured at fair value.• Most of the ‘added requirements’ were carried forward unchanged from IAS 39.• In December 2011 the IASB deferred the effective date to January 2015.•
  • IFRS 7• IFRS 7 Financial Instruments: Disclosures was issued in 2005 relocating disclosure portion of IAS 32 ( 1995) and including relevant disclosure issues contained in IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions (1990).• IFRS 7 disclosures are intended to enable users of the financial statements to evaluate:- the significance of financial instruments for the entity’sfinancial position and performance; and- the nature and extent of risks arising from financialinstruments, and how the entity manages those risks.
  • Accounting standards in India• In India , the following standards were issued:AS 30 Financial Instruments : Recognition &Measurement [Equivalent to IAS 39]AS 31 Financial Instruments : Presentation [Equivalent to IAS 32]AS 32 Financial Instruments : Disclosures [Equivalent to IFRS 7]Application of these standards are deferred.
  • Accounting standards in India• The following standards were issued in the process of IFRS convergence:Ind-AS 39 Financial Instruments : Recognition &Measurement [Equivalent to IAS 39]Ind-AS 32 Financial Instruments : Presentation [Equivalent to IAS 32]Ind-AS 107 Financial Instruments : Disclosures [Equivalent to IFRS 7]India has to initiate the process of upgrading Ind-AS39 to Ind-AS 109 in the line of the developments ofIFRS.
  • Purpose of IAS 32• IAS 32 Financial Instruments : Presentation defines financial assets , financial liabilities and equity and sets out principles for -• distinguishing financial liabilities and equity instruments;• recognition of compound financial instruments;• presentation of treasury shares ;• recognition of interest , dividend , losses or gains ; and• offsetting financial assets and financial liabilities.
  • Purpose of IAS 39(i) definition of derivatives ;(ii) classification of financial instruments into four categories ,namely , held for trading, held to maturities , loans andreceivables , and available for sale.(iii) principles to be followed for recognition and de-recognition of various categories of financial instruments ;(iv) trade date and settlement date accounting;(v) accounting for embedded derivatives ;(vi) reclassification of financial assets and financial liabilities;(vii) impairment and uncollectibility of financial assets ; and(viii) hedge accounting
  • Purpose of IFRS 9• IASB intends to replace IAS 39 in its entirety by IFRS 9 . Till date only Phase I is complete
  • Purpose of IFRS 7• Categories of financial assets and financial liabilities ;• Financial assets or financial liabilities at fair value through profit or loss ;• Financial assets measured at fair value through other comprehensive income;• Reclassification ;• Offsetting financial assets and financial liabilities ;• Collateral ;• Allowance account for credit losses ;• Compound financial instruments with multiple embedded derivatives;• Defaults and breaches;• Items of income, expenses, gain or losses;• Disclosures regarding hedge accounting.
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity
  • Meaning of Financial Instruments• Financial Instrument is a contract that gives rise to a financial asset to one entity, and a financial liability or an equity instrument to another entity.• Financial instruments include primary financial instruments like receivables , payables, loans and advances, debentures and bonds , investments in equity instruments, cash and bank balances, derivative instruments like options , futures, forwards , swaps, cap , collar, floor , forward rate agreement ( FRA) , etc.• A derivative with a positive value is financial asset and with negative value is financial liability.• In certain cases even a contract to buy or sell non-financial item may give rise to a financial asset or a financial liability.
  • Contractual Characteristics• Liabilities or assets that are not contractual (such as income taxes that are created as a result of statutory requirements imposed by governments) are not financial liabilities or financial assets. Accounting for income taxes is dealt with in accordance with IAS 12 Income Taxes. For example, tax liability and related advance payment of tax do not arise out of contract. Rather they arise out of legal requirements. So they are not treated as financial instruments.• Constructive obligations, as defined in IAS 37 Provisions, Contingent Liabilities and Contingent Assets, do not arise from contracts and are not financial liabilities.
  • Financial Instruments - analysed• Contractual right – absolute or contingent• Potential cash flows• Lease contracts
  • Contracts to buy or sell non-financial items treated as financial instruments• A contract to buy or sell financial items is treated as financial instrument when there is net settlement instead of giving or taking delivery. The primary identification criteria are –- net settlement by exchange of cash or another financialinstruments ; Net settlement may be explicit in the contract or bypractice followed by an entity while settling suchcontracts;- practice of short term profit taking by an entity ; and- ready convertibility of the non-financial items into cash.
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity
  • Meaning of Financial Assets (a) Cash – examples currency cash and bank deposit ; bank deposit reflects a contractual right to receive cash; but gold bullion is a commodity. (b) An equity instrument of another entity - example, investment in equity shares of another company ; (c) A contractual right - (i) to receive cash or another financial asset from another entity , or (ii) to exchange financial assets or financial liabilities with another entity for terms which are potentially favourable ; and(d) a contract that will or may be settled in the entity’s own equity instruments and is - (i) non – derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments , or (ii) 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.
  • Financial Liability (a) a contractual obligation : (i) to deliver cash or any other financial asset to another enterprise, and (ii) to exchange financial instruments with another enterprise for terms which are potentially unfavourable , (b) a contract that will or may be settled in the entity’s own equity instruments and is – (i) non – derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments , or (ii) 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.• Examples are accounts payable , bills payable , loans and advances payable , bank overdraft , debentures payable , outstanding expenses.
  • Note payable• Example A note payable in government bonds gives the holder the contractual right to receive and the issuer the contractual obligation to deliver government bonds, not cash. Is note payable a financial asset in the hands of the holder , and financial liability in the hands of the issuer.• Analysis : In one type of financial instrument the economic benefit to be received or given up is a financial asset other than cash. In the given example , the bonds are financial assets because they represent obligations of the issuing government to pay cash. The note is, therefore, a financial asset of the note holder and a financial liability of the note issuer.
  • Equity Instruments• An Equity instrument is a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.• To be classified as an equity instrument, an instrument must satisfy two conditions stated in Paragraph 16 (a) and (b)– (a) no contractual obligation to deliver cash , other financialinstruments to other entity or exchnage of financialinstruments in unfavourable terms to the issuer , and- (b) settlement of any contract that requires exchange ofown equity must be a contract to exchange fixed number ofown equity.
  • Equity Instruments…• No contractual obligation condition : To be classified as equity , the instrument includes no contractual obligation: (i) to deliver cash or another financial asset to anotherentity; or (ii) to exchange financial assets or financial liabilitieswith another entity under conditions that are potentiallyunfavourable to the issuer. [ Paragrph 16(a), IAS32]• An instrument that contains contractual dividend clause, repayment clause or put option to the holder is not an equity instrument.
  • Equity Instruments…Settlement of contract in fixed number of entity’sequity : In case an instrument will or may besettled in the issuer’s own equity instruments, andit is :(i) a non-derivative that includes no contractualobligation for the issuer to deliver a variablenumber of its own equity instruments; or(ii) a derivative that will be settled only by theissuer exchanging a fixed amount of cash or anotherfinancial asset for a fixed number of its own equityinstruments. [Paragraph 16 (b), IAS 32].
  • Equity Instruments…Examples of equity instruments include -• non-puttable ordinary shares,• some puttable instruments (see paragraphs 16A and 16B of IAS 32),• some instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation (see paragraphs 16C and 16D of IAS 32),• some types of preference shares (see paragraphs AG25 and AG26 of IAS 32), and• Warrants or written call option that allow the holder to subscribe for or purchase a fixed number of non-puttable ordinary shares in the issuing entity in exchange for a fixed amount of cash or another financial asset.
  • Case Analysis 1• A contractual right can be derivative as well. For example , under a futures contract X Ltd. has entered into 4 lots of Feb 2013 Futures contract in MCX to buy 100 MT ( lot size 25 MT) of Steelflat at an agreed price of Rs. 6,500 per MT. There is a practice of settling the transaction net based on settlement price of commodity exchange futures . On 31 December , 2012 X Ltd. finalises 3rd quarter accounts. As on that date settlement price is Rs. 6,600 per MT. Should this contract be classified as financial asset?
  • Solution to Case Analysis 1• A commodity derivative contract that contains a net settlement caluse is a financial instrument. Derivative with a positive value is financial asset. Under the contract, the carrying amount of the financial asset was Rs. 10,000 [ 100×(6600-6500)].
  • Financial Asset• [ Advance payment to buy financial asset] Is advance payment to acquire debentures of another entity or Government T-Bills or equity shares / preferences of another entity is a financial asset?• Analysis : Yes. Under Paragraph 11 ( c) (ii) of IAS 32 , advance payment signifies a contractual right of the entity to receive a financial asset , so it is a financial asset.
  • Case Analysis 2• [ Contractual right to receive cash or another financial asset from another entity - Investment in perpetual debt ]Akash Investment Ltd. invested in 8% Perpetual debt of face value Rs. 10,000 issuedby Delhi Auto Ltd. . How should this instrument be evaluated as an item of financialasset ?Analysis : This instrument gives a contractual right to the holder ( Akash Investment)to get a perpetuity of Rs. 800. It is measured in terms of present value applyingcurrent market yield. Assuming current market yield of that type of perpetual debtinstrument is 7% , then it is valued at - Rs. 800 ------------- = Rs. 11,429. 7%Similarly for Delhi Auto Ltd. it is a financial liability.
  • Case Analysis 3• Redeemable shares - a fixed redemption date or redemption at the holders 
discretion typically results in liability classification• A Ltd. issues 1,000 shares with a par value of Rs. 10 each. The holder of the shares has the option to require the company to redeem the shares at par at any given time. Whether these shares are classified as equity or liability ? How would the answer be different if the entity has the option to redeem the shares ?
  • Solution to Case Analysis 3• These shares are classified as liabilities unless classified as puttable instruments as equity under Paragraphs 16A & 16B , IAS 32. This is because A Ltd. does not have the ability to avoid the obligation to redeem the shares for cash should the holder exercise his option to redeem the shares.• If the option to redeem the entitys shares had instead been at the discretion of the issuer, the shares would have been classified as equity. In this case, the issuer has a right to pay cash to buy back the shares but no obligation to do so.
  • Case Analysis 4• Shares with mandatory dividend payments• B Ltd. issues preference shares with a par value of Rs. 100 each. The preference shares are non-redeemable but require the entity to make annual dividend payments @ 9 % on the par value. Are the preference shares classified as equity ?• Solution : No. Paragraph AG 26 , IAS 32 explains that non-redeemable preference shares are classified as equity if the dividend is optional but cumulative or non-cumulative. In the given case, dividend payment is mandatory so the preference shares are classified as liability.
  • Case Analysis 5• Financial instruments with payments based on profits of the issuer• X Ltd. issues 1,00,000 perpetual shares of Rs. 100 each on which it is liable to pay a 10% of its profits in each annual accounting period. Profit for this purpose means PAT of the company. Are these shares classified as equity ?• Solution : No. An instrument which contains an obligation to pay mandatory payments either on the amount of par value of shares or as a percentage of profit is classified as a financial liability.
  • Case Analysis 6• X Ltd. has issued 1,00,000 non-redeemable preference shares. The instruments contain a condition that the issuer has to transfer a property to the holder of the instrument if it fails to make dividend payments. Should the instrument be classified as an equity or a financial liability?
  • Solution to Case Analysis 6• The instrument contains a contractual obligation to pay dividend. As per Paragraph 20(a) , IAS 32 if the entity can avoid a transfer of cash or another financial asset only by settling the non-financial obligation, the financial instrument is a financial liability. In the given case, obligation to settle by transfer of property creates an indirect obligation to make the dividend payments, and the instrument is therefore classified as a liability.
  • Preference shares• Preference shares having mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date is a financial liability. Similarly , preference shares which have attached put option by which the holders enjoy the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount is also classified as financial liability.
  • Preference shares• Potential inability to redeem : Sometime it may appear that issuer will be unable to meet the redemption condition attached to preference shares . There may be many reasons for this inability important of which are insufficient project cash flows , a statutory restriction , insufficient profits. However, the potential redemption inability does not negate the obligation.• Despite of potential inabilities the preference shares shall be classified as financial liability.
  • Preference shares• Call option of the issuer : The preference shares may have attached call option such that the issuer can buy back those shares . This call feature does not make the preference shares automatically redeemable. This kind of preference shares are classified as equity until the issuer notifies its intention to call those shares. Once the intention is notified , then the preference shares are re-classified as financial liability.
  • Preference shares• Distribution feature : A compulsory distribution of dividend at a fixed rate would make the preference a financial liability. But if the distribution ( cumulative or non- cumulative) is to be approved by the Board it loses the compulsory distribution feature and classified as equity.
  • Classification of Equity• Fixed test for non-derivative contract• Fixed to Fixed test for derivative contracts
  • The fixed test for non-derivative instruments• A non-derivative contract that is to be settled by delivering fixed number of entity’s own equity instruments is an equity. A contract to deliver a variable number of own equity instruments equal in value to a fixed monetary amount on the settlement date is classified as a financial liability.• The underlying principle behind the fixed test is that using a variable number of own equity instruments to settle a contract can be similar to using own shares as currency to settle what in substance is a financial liability. Such a contract does not evidence a residual interest in the entitys net assets. Equity classification is therefore inappropriate.
  • Case Analysis 7• [ Shares used as currency]• Entity A issues a debt instrument for which it receives Rs. 100,000. Under the terms of the issue, Entity A will repay the debt in 3 years time by delivering ordinary shares to the value of Rs. 145,000. Should this instrument be classified as equity ?• Solution : Entity A is using its own shares as currency, and the instrument should therefore be classified as a financial liability.
  • Case Analysis 8• [ Shares to the value of a commodity]• Entity B issues preference shares for Rs. 1,00,000. The shares pay no dividend and will be settled in three years time by Entity A delivering a number of its own ordinary shares (which are correctly classified as equity) as are equal to the value of 100 ounces of gold. Can the preference shares be classified as equity under the fixed for fixed test?• Solution : No. The shares must be classified as financial liabilities as the delivery of ordinary shares to the value of 100 ounces of gold represents an amount that fluctuates in part or in full in response to changes in a variable other than the market price of the entitys own equity instruments. [ IAS 32.21].
  • The Fixed for fixed test for derivative instruments• In the case of a derivative financial instrument which is to be settled by an entity issuing its own equity instruments, it is classified as equity if and only if the fixed for fixed test is satisfied.• The fixed for fixed test is therefore typically crucial when an entity issues (i) a convertible bond or (ii) share warrants or options.• Fixed for fixed test is satisfied in the derivative contracts presented in the Table below. In case of the option contracts , strike price indicates fixed cash to be exchanged and lot size of the contracts specifies fixed number of own equity to be exchanged in return. Similarly, forward / futures price and lot size of forward/ futures contracts satisfy fixed for fixed test.
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity
  • Puttable Instruments as Equity• Generally, a puttable instrument is classified as a financial liability not as an equity instrument. Exceptions are set out in Paragraphs 16A & 16 B of IAS 32.
  • Puttable Instruments as Equity..• Conditions to be satisfied for classifying a puttable instruments for classification as an equity instrument ( Paragraphs 16A & 16B , IAS 32 ) are instrument specific and issuer specific .
  • Instrument specific conditions• Pro-rata distribution of net assets on liquidation• The puttable instrument is sub-ordinated to all other classes of instrument. It has no prior claim on the assets of the issuer on liquidation before any other category of instrument nor it is to be converted to reach the status of sub- ordinated instrument.
  • Issuer specific Conditionsi. The issuer has no other financial instrumentwhich has expected cash flow that can beattributable to the instrument over its life are – (a)profit or loss , (b) change in recognised net assetsand (c ) fair value change in recognised andunrecognised net asset of the entity ; andii The issuer has no other financial instrumentwhich has the effect of substantially restricting orfixing the residual return to the puttable instrumentholders.
  • Example of puttable instruments as equity• Example : An open-ended mutual fund issues units to the unitholders which contains a repurchase feature , i.e. the unit holders can offer their units for repurchase. Therefore , these units are puttable instruments. Can they be classified as equity ?• Solution : It is to be verified that whether (i) the open ended mutual fund can issue only one class of units that ensures pro-rata distribution of its net assets in the eventuality of liquidation of the fund ; all units will then carry same features , (ii) such units are sub- ordinated to all other liabilities of the fund , (iii) the obligation of the issuer relates to only to repurchase or redeem the units and (iv) expected return on units depends on the profit / loss of the funds. If all the above-mentioned conditions are fulfilled , then by virtue of IAS 32.16A and IAS 32.16B units of mutual funds having repurchase feature can be classified as equity instruments.
  • Obligation to Pro-rata Distribution• Instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation are classified as equity on the fulfilment of (i) instrument specific and (ii) issuer specific conditions.
  • Instrument specific conditions [ Paragraph 16 C, IAS 32]i. The holder of the instrument is entitled to a pro rata share of the entity’s net assetsin the event of the entity’s liquidation. The entity’s net assets are those assets thatremain after deducting all other claims on its assets. Net assets in event of entity’s liquidationA pro-rata share in net asset per unit = ------------------------------------------------------ No of shares / units outstandingThis is multiplied by the number of units which a holder possesses.ii. The instrument is sub-ordinated to all other classes of instrument. It has no priorclaim on the assets of the issuer on liquidation before any other category ofinstrument nor it is to be converted to reach the status of sub-ordinated instrument.iii. All instrument belonging to this class must have an identical contractual obligationfor the issuing entity to deliver a pro rata share of its net assets on liquidation.
  • Issuer specific Conditions [ Paragraph 16D , IAS 32]i. The issuer has no other financial instrument which hasexpected cash flow that can be attributable to theinstrument over its life are – (a) profit or loss , (b) changein recognised net assets and (c) fair value change inrecognised and unrecognised net asset of the entity; andii The issuer has no other financial instrument which hasthe effect of substantially restricting or fixing the residualreturn to the e instrument holders.In case the entity cannot carry the tests under Paragraph16D , the instrument having obligation to pro-ratadistribution is classified a financial liability.
  • Accounting for Financial InstrumentsSession 1 : Introduction to Financial Instruments [9.30 – 11.00 AM]• Introduction to financial instruments standards• Definition of financial instruments• Definition of financial asset, financial liability and equity• Puttable Instruments as equity• Obligation for pro-rata distribution in liquidation as equity• Financial Guarantee
  • Financial Guarantee• A financial guarantee is a contract that requires the issuer to make specified payments to reimburse the holder for a loss that it incurs because a specified debtor fails to make a payment when due in accordance with the original or modified terms of a debt instrument.• The issuer of such a financial guarantee would account for it initially at fair value under IAS 39, and subsequently at the higher of that amount initially recognised less cumulative amortisation recognised in accordance with IAS 18 or the amount determined in accordance with IAS 37.• Guarantees based on an underlying price or index are derivatives within the scope of IAS 39.
  • Financial Guarantee…• The issuer has the choice to elect a financial guarantee contract as an insurance contract and account for the same in accordance with the accounting applicable to insurance contracts.• Therefore, the issuer may elect to apply either IAS 39 or IFRS 4 to such financial guarantee contracts.
  • Financial Guarantee : Case Analysis• If a $10,000 loan is drawn down so that the borrower can acquire machinery from a dealer, and a third party agrees to guarantee this debt to the bank for a onetime premium of $250, for a loan term of four years, that amount probably represents the fair value of the loan guarantee, which should be recorded accordingly. If it qualifies under IAS 18 for recognition as revenue on a straight-line basis, it would be amortized to income at the rate of $62.50 per year.• Assume that, subsequently, the machinery purchaser’s creditworthiness is impaired by a severe downturn in its industry segment performance, so that, by the end of the second year, the fair value of this guarantee (which has two more years to run) is $200. That could be measured, among other ways, by the onetime premium that would be charged to transfer this risk to another arm’s-length guarantor.
  • Financial Guarantee : Example 1 contd• Since the carrying value of the liability is $125 after two years’ amortization has occurred, the higher of the amount determined under IAS 37 or the carrying value, $200 must be reported in the statement of financial position as the guarantee obligation. An expense of ($200 – $125 =) $75 must be recognized in the current (second) year as the cost of the additional risk borne by the reporting entity (but note that $62.50 in fee income is also being recognized in that year). The new book value, $200, will be amortized over the remaining two years ratably, assuming that no default occurs.• Note that IAS 37 stipulates that the “best estimate” of the amount to be reported as a provision is the amount that would rationally be offered to eliminate the obligation. In general, this should match with the notion of “fair value.” Both imply a probability-weighted assessment, which may be made explicitly or implicitly depending upon the circumstances. Both also imply a present value equivalent of future resource outflows, assuming that the timing of such outflows could be estimated.
  • Sales inducement guarantee• In case the guarantee is a sales inducement (e.g., when the machinery dealer finds it must guarantee the buyer’s bank loan in order to consummate the sale), and thus is effectively a discount on the price otherwise obtainable for the merchandise (or services).• The full expense would be recognized at the date of the transaction since this expense was incurred in order to generate the sale; thus it is best “matched” against revenue recognized in the current reporting period. The guarantee liability is accounted for as set forth above (adjusted to the higher of fair value or amortized original value, if amortization is proper under IAS 18).
  • End of Session 1