Background :

Accounting Standards (AS) 30 and 31 have been issued by our Institute and will come into effect from April 1, 2011 with early adoption being recommendatory. AS-30 deals with recognition and measurement of financial instruments (including derivatives). AS-31 deals with presentation aspects and, in particular, with distinction between liabilities and equity. This distinction can be complex where corporates issue instruments like convertible debentures and foreign currency convertible bonds, which carry features of both debt and equity. AS-32 deals with disclosures. Small and medium entities are exempted from these Standards.

Chartered Accountants are likely to find these Standards challenging in view of the sheer size (336 pages in all) and complexity of the content as well as, in many cases, lack of exposure to the domain of derivatives and complex instruments. The Barclays Bank Annual Report of 2007 is a 150+ page document, more than one thirds of which is devoted to disclosures required under the equivalent of AS-32 in the IFRS framework.

These three Articles propose to de-mystify the accounting of key aspects of these important Standards.

Financial engineering and innovation are increasingly making inroads into the lives of common people. The annual GDP of the world is estimated by experts to be in the region of $ 50 bio, while derivative open positions are estimated to be more than $ 500 bio. Thus, the derivative world is much larger than the ‘real’ world of real goods and real services.

Our own equity derivatives market daily turnover in Jan. 2008 was Rs.1 lakh crores per day as against an equity market turnover of Rs.25,000 crores (at that time). In a short span of less than 8 years, the derivative market has grown to four times the underlying equity market. While on the one hand, this proliferation of derivatives has created huge crises in the world, including the subprime crisis, on the other hand, it has created huge challenges for the accounting community which in many situations does not comprehend the implications of such instruments on risk, on potential earnings, on actual reported earnings and on recognition of assets or liabilities as a result of such exposures.

AS-30 provides guidance on classification, initial measurement, subsequent measurement and de-recognition of financial assets, financial liabilities, derivatives and hedge accounting. Impairment of financial assets, securitisation and guidance on fair valuation are also covered in AS-30. Hedge accounting is a complex and vast area of literature covering fair value hedges, cash flow hedges and hedges of net investment in foreign operations.

A financial instrument is a contract that gives rise to a financial asset for one entity and a financial liability or equity for the other. A financial asset is :

• certain contracts that will or may be settled in the entity’s own equity instruments.

A financial liability is :

• a contractual obligation to deliver cash or other financial asset to another entity

• a contractual obligation to exchange financial assets or liabilities with another entity on conditions that are potentially unfavourable to the entity

• certain contracts that will or may be settled in the entity’s own equity instruments.

Common examples of financial assets and liabilities are cash and bank balances, accounts receivable and payable, bills receivable and payable, loans receivable and payable, bonds receivable and payable, deposits and advances. Contingent rights and obligations like in the case of financial guarantees are financial assets or liabilities, notwithstanding the fact that they may not be recognised on the balance sheet.

Finance lease receivables and payables are financial assets or liabilities as these are blended amounts comprising principal and interest on the lease. An operating lease contract does not represent financial assets or liabilities as the contracted amount is indicative of future services to be provided by the lessor. The amount already due to be received or paid under an operating lease is a financial asset or liability.

Prepaid expenses, deferred revenues and warranty obligations are not financial assets or liabilities as they represent the right to receive goods or services and not cash. Income taxes and deferred taxes are not financial assets or liabilities as they are not contractual obligations but statutory obligations.

All financial assets and liabilities are required to be recognised at fair value at initial recognition. For financial assets and liabilities which are classified as at fair value through P&L, transaction costs are charged to P&L at the point of initial recognition itself. For other financial assets and liabilities, the carrying value at initial recognition includes transaction costs (which are added to or deducted from fair value as the case may be).

Example — if an entity buys equity shares of L&T for Rs.1,500 and incurs brokerage and other transaction costs of Rs.2, the carrying value of these shares will be Rs.1,500 if these are classified as ‘fair value through P&L’ and Rs.1,502 if these are classified as ‘available for sale’ securities.

Short-term receivables and payables with no stated interest rate are measured at invoice amount if the effect of discounting is immaterial.

Financial assets are classified into four possible categories and financial liabilities into two possible categories as summarised in the following table. The framework for subsequent measurement (which could be at fair value, cost or amortised cost), recognition of mark-to-market gains and losses and impairment testing principles are also provided.

The table below is subject to the principles of hedge accounting which are discussed later in these Articles. When principles of hedge accounting are applied, the above recognition framework will be overridden by those principles.

Let’s now discuss each class of assets and liabilities in detail.

Financial assets which are classified in this basket are carried at fair value in the balance sheet, with mark-to-market gains or losses being carried into the P&L. Fair valuation of such assets will result in earnings becoming volatile to the extent that such assets fluctuate in value from quarter to quarter. Financial assets held for trading belong here and so do derivatives which are not designated as hedging instruments. The Standard also permits management to designate qualifying financial assets into this basket in the following situations :

Initial measurement of loans and receivables is at fair value plus transaction costs. Subsequent measurement is at amortised cost, except for short-term receivables which is at invoice amount if the effect of discounting is immaterial, if there is no stated interest rate in the invoice.

The concept of ‘amortised cost’ involves mathematical computations to which accountants are not accustomed in current practice and hence needs to be discussed in detail.

Your entity has provided a loan of Rs.25 lakhs at 12% interest (payable annually in arrears) and has collected a processing fee of Rs.1 lakh (4%) for this loan. The loan is repayable after 5 years (one bullet payment).

Regular interest income on the loan will be Rs.3 lakhs per annum (Rs.25 lakhs x 12%). The processing fee income of Rs.1 lakh is required to be amortised over the five-year tenor of the loan in a manner that the effective interest rate over this five-year period is constant.

If the cash flows of the loan are tabulated and an IRR function applied to these cash flows, the effective interest rate works out to 13.1412%. Thus the carrying value of the loan will be Rs.24 lakhs on day zero (Rs.25 lakhs disbursed minus Rs.1 lakh collected as fees). On this amount, income for year one will be computed as Rs.3.1539 lakhs. At the end of year one, the carrying value of the loan (at amortised cost) will increase to Rs.24.1539 lakhs (Rs.24 lakhs opening plus yield accrual of Rs.3.1539 minus collection of Rs.3 lakhs). This process will continue over the five-year tenor of the loan with carrying value becoming zero on repayment of principal at the end of the term.

Readers can imagine the complexity that financial institutions disbursing thousands of loans every year will face. In practice, loans are not repaid in bullet at the end of the tenor and could be repaid on a monthly basis, transactions happen every day and not neatly at the beginning of the financial year as in the above example (where IRR would not be adequate and XIRR would be called for), interest rates are not fixed but floating, processing fees vary, there are origination costs apart from fees (which require similar amortisation treatment), contractual tenor is not the same as actual tenor in view of prepayments and sometimes rescheduling due to late payments and hence actual tenor is not known upfront.

Article by Raghu Iyer, Chartered Accountant