Analysis of Ind AS 109, Financial Instruments

Introduction: Ind AS 109, Financial Instruments, is a pivotal standard in the landscape of financial reporting, setting the stage for a transparent and informative disclosure of financial assets and liabilities. This standard is designed with the ultimate goal of furnishing users of financial statements with critical insights into an entity’s future cash flows, focusing on the amounts, timing, and the inherent uncertainty. It governs a wide array of financial instruments while delineating clear exceptions, thereby ensuring applicability across diverse entities. Through its comprehensive scope, Ind AS 109 enables entities to adopt a structured approach towards the classification, recognition, measurement, and derecognition of financial instruments, thereby facilitating a nuanced understanding of an entity’s financial health and risk exposure.

Ind AS 109, Financial Instruments,

Ind AS 109, Financial Instruments, sets out principles for the financial reporting of financial assets and financial liabilities with the aim of providing relevant and useful information to users of financial statements. The standard focuses on enabling users to assess an entity’s future cash flows in terms of amounts, timing, and uncertainty.

Scope: Ind AS 109 applies to all entities and covers all types of financial instruments, excluding specific cases:

• Interests in subsidiaries, associates, and joint ventures: Except those accounted for under Ind AS 110, Ind AS 27, or Ind AS 28.
• Leases: Rights and obligations under leases governed by Ind AS 116, except for lease receivables, which are subject to derecognition and impairment requirements of Ind AS 109.
• Employee Benefit Plans: Excluding employers’ rights and obligations under employee benefit plans governed by Ind AS 19.
• Equity Instruments: Financial instruments issued by the entity meeting the definition of an equity instrument.
• Insurance Contracts: Rights and obligations arising under insurance contracts or contracts within the scope of Ind AS 104 containing a discretionary participation feature.
• Forward Contracts for Business Combinations: Excluding any forward contracts to buy or sell an acquiree resulting in a business combination under Ind AS 103.
• Loan Commitments: With exceptions for those designated as financial liabilities at fair value through profit or loss, loan commitments that can be settled net in cash, or commitments to provide a loan at a below-market interest rate.
• Share-based Payment Transactions: Excluding contracts under Ind AS 102, Share-based Payment, except for contracts to buy/sell non-financial assets within the scope of this standard.
• Rights to Payments for Expenditure: Rights to payments to reimburse the entity for expenditure to settle a recognized liability under Ind AS 37.
• Revenue from Contracts with Customers: Except for financial instruments within the scope of Ind AS 115, unless specified otherwise by Ind AS 115.
• Contracts for Non-financial Items: Contracts to buy or sell a non-financial item that cannot be settled net in cash, another financial instrument, or by exchanging financial instruments.

Example: If a company has a forward contract to buy or sell an acquiree, that contract falls outside the scope of Ind AS 109 unless it results in a business combination within the scope of Ind AS 103. In such a case, the accounting treatment would follow the guidelines of Ind AS 103 rather than Ind AS 109.

Recognition: Entities recognize financial assets or financial liabilities in their balance sheets when they become parties to the contractual provisions of the instrument. In other words, recognition occurs when the entity has rights to receive cash flows from a financial asset or has obligations to deliver cash flows for a financial liability.

Derecognition of Financial Assets: Financial assets are derecognized when the contractual rights to the cash flows expire, or when the asset is transferred and qualifies for derecognition. If derecognition is in entirety, the difference between the carrying amount and consideration received is recognized in profit or loss. For partial derecognition, the carrying amount is allocated between the recognized and derecognized parts based on their relative fair values.

Derecognition of Financial Liabilities: Financial liabilities are derecognized when extinguished (i.e., the obligation specified in the contract is discharged, cancelled, or expires). Substantial modifications to the terms of contracts are treated as extinguishment of the original liability, and any difference between the carrying amount and consideration paid is recognized in profit or loss.

Classification of Financial Assets: Financial assets are classified and measured at amortized cost, fair value through other comprehensive income (FVTOCI), or fair value through profit or loss (FVTPL) based on the entity’s business model for managing the assets and the contractual cash flow characteristics.

• Amortized Cost: If the business model is to collect contractual cash flows and the terms give rise to specified dates for cash flows of principal and interest.
• Fair Value through Other Comprehensive Income (FVTOCI): If the business model involves collecting cash flows and selling financial assets, and the terms give rise to specified dates for cash flows of principal and interest.
• Fair Value through Profit or Loss (FVTPL): For other financial assets, unless irrevocably designated at initial recognition. An entity may make irrevocable elections for certain equity instruments to present subsequent changes in fair value in other comprehensive income. This is permitted if it eliminates or significantly reduces accounting mismatch.

Example: Suppose Company A holds a bond in its portfolio intending to collect contractual cash flows. The bond’s terms specify principal and interest payments on specified dates. Company A would classify and measure this financial asset at amortized cost. If another financial asset involves both collecting cash flows and selling assets, and meets the criteria for FVTOCI, it would be classified accordingly. Any financial asset not meeting the criteria for amortized cost or FVTOCI is measured at fair value through profit or loss unless an irrevocable election is made for other comprehensive income presentation to address accounting mismatches.

Classification of Financial Liabilities: Financial liabilities are classified as subsequently measured at amortized cost, except for specific cases:

• Financial Liabilities at Fair Value through Profit or Loss (FVTPL): Those measured at fair value with changes recognized in profit or loss.
• Liabilities from Transfers of Financial Assets: When a transfer of a financial asset doesn’t qualify for derecognition or when the continuing involvement approach applies.
• Financial Guarantee Contracts: Contracts providing a guarantee for a third party’s financial obligation.
• Commitments to Provide a Loan at a Below-market Interest Rate: Agreements to lend at interest rates below the prevailing market rate.
• Contingent Consideration in Business Combinations: Consideration recognized by an acquirer in a business combination to which Ind AS 103 applies.

An entity can irrevocably designate a financial liability at fair value through profit or loss at initial recognition.

Embedded Derivatives: An embedded derivative is a part of a hybrid contract (combination of derivative and non-derivative) causing cash flows similar to a standalone derivative.

Reclassification: When an entity changes its business model for managing financial assets, it must reclassify all affected financial assets.

Measurement on Initial Recognition:

• Financial assets or liabilities at FVTPL: Measure at fair value on the recognition date, with transaction costs expensed in profit and loss.
• Other financial assets/liabilities: Measure at fair value plus or minus directly attributable transaction costs.

Fair Value Measurement: Determined per Ind AS 113 Fair Value Measurements. Normally, the fair value is the transaction price, but if the consideration includes non-financial elements, fair value is assessed.

Subsequent Measurement: After initial recognition, financial assets and liabilities are measured based on their classification.

• If fair value differs from the transaction price:

• If based on quoted price or observable markets, recognize the difference as gain or loss.
• Otherwise, adjust fair value to defer the difference, recognizing it later only if arising from factors market participants consider.

Example: Suppose Company B issues bonds at a below-market interest rate. These bonds would fall under commitments to provide a loan at a below-market interest rate, and the entity cannot classify them at amortized cost. Instead, they would be classified as subsequently measured at fair value through profit or loss. If Company B decides to change its business model for managing financial assets, it must reclassify all affected financial assets accordingly. Initial measurement of these bonds would involve assessing fair value and transaction costs. If fair value differs from the transaction price, Company B would account for the difference based on the criteria mentioned – recognizing gains or losses depending on the nature of the fair value determination.

Changes in the Basis for Determining Contractual Cash Flows due to Interest Rate Benchmark Reform:

Overview: Ind AS 109 provides a practical expedient for entities facing changes in the basis for determining contractual cash flows due to interest rate benchmark reform. This reform may necessitate adjustments to financial assets or liabilities to replace or modify interest rate benchmarks. The practical expedient aims to simplify the accounting treatment for such changes.

Conditions for Application: The practical expedient is applicable when there is a change in the basis for determining contractual cash flows due to interest rate benchmark reform. The change can occur in various ways:

• Change in Contractual Terms: For example, amending terms to replace the referenced interest rate benchmark with an alternative benchmark rate.
• Unanticipated Alteration: Changes not considered or anticipated initially, such as alterations in the method for calculating the interest rate benchmark without amending contractual terms.
• Activation of Existing Terms: Triggering existing fallback clauses in the contract.

Conditions for Interest Rate Benchmark Reform: The interest rate benchmark reform triggers changes in the basis for determining contractual cash flows only if both conditions are met: a. Necessity: The change is a direct consequence of interest rate benchmark reform. b. Economic Equivalence: The new basis for determining contractual cash flows is economically equivalent to the previous basis.

Application of the Practical Expedient: When changes are made to a financial asset or liability due to interest rate benchmark reform, the entity applies the practical expedient. If additional changes are made beyond those required by the reform, the entity first applies the practical expedient to the reform-related changes. Subsequently, any additional changes are subjected to the applicable requirements of Ind AS 109 that are not covered by the practical expedient.

Example: Suppose Company C has issued bonds with an interest rate benchmark tied to LIBOR. Due to the phase-out of LIBOR, regulatory authorities mandate a transition to an alternative benchmark rate. In response, Company C amends the contractual terms of the bonds to replace LIBOR with the new benchmark. This is a change in the basis for determining contractual cash flows triggered by interest rate benchmark reform.

Company C, following the practical expedient under Ind AS 109, assesses whether the change meets the conditions: it is a direct consequence of the benchmark reform, and the new basis is economically equivalent to the previous one. If these conditions are met, Company C applies the practical expedient for accounting purposes. Any additional changes unrelated to the interest rate benchmark reform are separately addressed following the applicable requirements of Ind AS 109.

Expected Credit Loss (ECL):

Overview: Expected Credit Loss is a measure of potential credit losses weighted by the respective risks of default, providing a forward-looking assessment of credit risk. This is used to recognize loss allowances on financial instruments based on the expected credit losses.

Calculation of Credit Loss: Credit loss is determined as the difference between all contractual cash flows due in accordance with the contract and the expected cash flows the entity anticipates receiving, discounted at the original effective interest rate.

Recognition of Loss Allowance: Loss allowances for expected credit losses are recognized on financial assets measured at Fair Value through Other Comprehensive Income (FVTOCI) and Fair Value at Amortized Cost, lease receivables, contract assets, loan commitments, and financial guarantee contracts subject to impairment requirements.

• For financial instruments with increased credit risk, the loss allowance is measured at an amount equal to lifetime expected credit losses.
• For purchased or originated credit-impaired financial assets, cumulative changes in lifetime expected credit losses since initial recognition are recognized as a loss allowance.

Special Cases:

• Trade Receivables or Contract Assets within the scope of Ind AS 115: Loss allowance is measured at an amount equal to lifetime expected credit losses if they lack a significant financing component or if the entity chooses this policy for those with a significant financing component.
• Lease Receivables within the scope of Ind AS 116: Loss allowance is measured at an amount equal to lifetime expected credit losses if the entity chooses this accounting policy.

Measurement Criteria: Expected credit losses are determined in an unbiased and probability-weighted manner, considering a range of possible outcomes, time value of money, and reasonable, supportable information available at the reporting date about past events, current conditions, and forecasts of future economic conditions.

Recognition in Profit or Loss: Impairment gains or losses, representing the amount of expected credit losses (or reversal), are recognized in profit or loss. This adjustment ensures the loss allowance at the reporting date aligns with the amount required by the Standard.

Example: Suppose Company D has a trade receivable resulting from a transaction within the scope of Ind AS 115. The entity determines that the receivable has a significant financing component and chooses to measure the loss allowance at an amount equal to lifetime expected credit losses. At each reporting date, Company D assesses the credit risk, and if it has increased significantly since initial recognition, the loss allowance is measured accordingly.

Additionally, Company D holds a lease receivable within the scope of Ind AS 116 and chooses to measure the loss allowance at an amount equal to lifetime expected credit losses. The same assessment is applied separately to finance and operating lease receivables. The measurement considers a range of possible outcomes, reflecting an unbiased and probability-weighted amount, and the resulting impairment gain or loss is recognized in profit or loss to align the loss allowance with the requirements of Ind AS 109.

Gains and Losses on Financial Assets or Liabilities Measured at Fair Value:

Recognition in Profit or Loss: Gains or losses on financial assets or liabilities measured at fair value are recognized in profit or loss unless they meet specific criteria:

• Part of a hedging relationship.
• Investment in an equity instrument with an option to present gains and losses in other comprehensive income.
• Financial liability designated as at fair value through profit or loss.
• Financial asset measured at fair value through other comprehensive income.

Example: Company E holds a portfolio of bonds measured at fair value. At the end of the reporting period, the fair value of these bonds has changed. The resulting gain or loss would typically be recognized in profit or loss. However, if these bonds are part of a hedging relationship or are an investment in an equity instrument with the option to present gains and losses in other comprehensive income, the accounting treatment may differ.

Hedge Accounting:

Objective of Hedge Accounting: The goal of hedge accounting is to reflect in the financial statements the impact of risk management activities using financial instruments to manage exposures to specific risks that could impact profit or loss or other comprehensive income.

Hedging Instruments:

• Derivatives measured at fair value through profit or loss may be designated as hedging instruments.
• Non-derivative financial assets or liabilities measured at fair value through profit or loss may also be designated, unless they are financial liabilities with fair value changes attributable to credit risk changes presented in other comprehensive income.
• Only contracts with external parties can be designated as hedging instruments.

Hedged Items: A hedged item can be a recognized asset or liability, an unrecognized firm commitment, a forecast transaction, or a net investment in a foreign operation. It must be reliably measurable.

Types of Hedging Relationships:

Fair Value Hedge:

• Hedges exposure to changes in fair value of a recognized asset or liability, an unrecognized firm commitment, or a component of such items attributable to a particular risk affecting profit or loss.

Cash Flow Hedge:

• Hedges exposure to variability in cash flows attributable to a particular risk associated with a recognized asset or liability, a highly probable forecast transaction, or a component of such items that could impact profit or loss.

Hedge of a Net Investment in a Foreign Operation: As defined in Ind AS 21, this hedge protects against exchange rate fluctuations affecting the net investment in a foreign operation.

Example: Company F, anticipating variable cash flows due to fluctuations in interest rates, designates a derivative instrument as a cash flow hedge. The derivative’s fair value changes would be recognized in other comprehensive income to offset the variability in cash flows associated with the hedged item. This aligns with the objective of hedge accounting to reflect the risk management activities in the financial statements.

Qualifying Criteria for Hedge Accounting:

Eligibility of Instruments and Items: The hedging relationship must consist only of eligible hedging instruments and eligible hedged items.

Formal Designation and Documentation: At the inception of the hedging relationship, there should be formal designation and documentation of the hedging relationship. This includes outlining the entity’s risk management objective and strategy for the hedge.

Hedge Effectiveness Requirements: The hedging relationship must meet the following effectiveness requirements:

(i) Economic Relationship: There must be an economic relationship between the hedged item and the hedging instrument.

(ii) Dominance of Credit Risk: The effect of credit risk should not dominate the value changes resulting from the economic relationship.

(iii) Hedge Ratio Consistency: The hedge ratio of the relationship must be the same as that resulting from the quantity of the hedged item actually hedged and the quantity of the hedging instrument actually used.

Rebalancing in Case of Hedge Ratio Change: If a hedging relationship ceases to meet the hedge effectiveness requirement related to the hedge ratio, but the risk management objective remains the same, the entity should adjust the hedge ratio through a process called ‘rebalancing.’

Prospective Discontinuation: Hedge accounting is discontinued prospectively only when the hedging relationship or part of it ceases to meet qualifying criteria, taking into account any rebalancing.

Disclosures: Detailed disclosures are required by Ind AS 109, explaining the impact of hedge accounting on financial statements, the entity’s risk management strategy, and details about derivatives affecting future cash flows.

Example: Company G enters into a hedging relationship to mitigate the risk of interest rate fluctuations affecting its variable-rate debt. The hedging instrument, a derivative, is designated to offset changes in the fair value of the debt. Formal documentation outlines the risk management strategy. The hedge effectiveness requirements are met, ensuring an economic relationship, minimal impact from credit risk, and consistency in the hedge ratio. The company regularly assesses and rebalances the hedge ratio if needed. Disclosures in financial statements provide transparency about the hedging relationship and its impact on the company’s financial position.

Temporary Exceptions from Hedge Accounting Requirements:

Interest Rate Benchmark Reform:

• The standard provides exceptions from specific hedge accounting requirements for hedging relationships directly affected by interest rate benchmark reform.
• The reform refers to the market-wide change of an interest rate benchmark, including replacing it with an alternative benchmark resulting from recommendations like those in the Financial Stability Board’s July 2014 report.

Directly Affected by Interest Rate Benchmark Reform:

• A hedging relationship is directly affected if the reform introduces uncertainties about the designated hedged risk or the timing/amount of interest rate benchmark-based cash flows.

Temporary Exceptions:

• The standard provides temporary exceptions assuming the interest rate benchmark on which hedged cash flows are based remains unaltered due to the reform.
• Exceptions include determining the highly probable requirement for cash flow hedges, reclassifying amounts in the cash flow hedge reserve, and assessing the economic relationship between the hedged item and the hedging instrument.

Ceasing Exceptions: The standard specifies when to prospectively cease applying these exceptions.

Example: Company H, facing uncertainties due to interest rate benchmark reform, enters into hedging relationships to manage cash flow exposures. The standard provides temporary exceptions, allowing the company to assume that the benchmark on hedged cash flows remains unaltered during the reform. This ensures continuity in applying specific hedge accounting requirements during the period affected by the reform. The company will cease these exceptions as per the specified conditions in the standard.

Conclusion: Ind AS 109, Financial Instruments, stands as a cornerstone in the edifice of financial reporting, providing a robust framework for the disclosure and analysis of financial assets and liabilities. By articulating principles for recognition, measurement, and derecognition, it empowers users to make informed decisions based on a detailed assessment of future cash flows and their associated risks. The standard’s exhaustive coverage, from hedging activities to expected credit losses, ensures that entities can navigate the complexities of financial instruments with precision. Moreover, the provisions for hedge accounting and the practical expedients for interest rate benchmark reform highlight Ind AS 109’s adaptability to evolving financial landscapes. In essence, Ind AS 109 not only enhances transparency and reliability in financial reporting but also aligns the reporting practices with the dynamic needs of stakeholders, ensuring that financial statements remain a vital tool for economic analysis and decision-making.