Thursday, September 29, 2016

Effective Interest Rate (EIR): Floating (Variable)- Rate Financial Instruments

I have been receiving a number of queries on calculation of effective interest rate for floating (variable) rate financial assets or financial liabilities – which are to be subsequently measured at amortised cost.

Let’s first start with the definition of ‘Effective Interest Method’. Indian Accounting Standard (Ind AS) 109, Financial Instruments in Appendix A states that ‘the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses (ECL). The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate, transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).’

The definition is lucid and almost explains the calculation of effective interest rate in all the scenarios. The Application Guidance in Appendix B of the standard while elucidating on amortising yield enhancing fees and/or costs over the expected life of financial asset or financial liability mentions EIR of floating (variable) rate instruments. For floating (variable)-rate financial assets or financial liabilities, periodic re-estimation  of cash flows to reflect the movements in the market rates of interest alters the effective interest rate. If the floating (variable)-rate financial asset or financial liability is recognized initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability.


To sum it up, in the floating (variable)-rate financial asset or liability any fees, transaction costs, premiums or discount will be amortised at EIR till the next interest repricing date. If such transaction costs are not material to be included in the EIR calculation then amortised cost of financial asset or financial liability would be the carrying amount.

Wednesday, September 28, 2016

Clarification by SEBI regarding Revenue recognition and Excise Duty Restrictions




Transition to Indian Accounting Standards (Ind AS) has brought a set of challenges for companies as well as the regulators. SEBI vide its circular dated 5 July 2016 (CIR/CFD/FAC/62/2016) requires listed companies to comply with the formats prescribed under the SEBI Circular dated 30 November 2015, for reporting financial results till 31 December 2016. The 31 March 2017 financial results onwards are required in the formats prescribed in Revised Schedule III of the Companies Act 2013.

The format prescribed by SEBI permits ‘Income from Operations’ to be disclosed net of excise duty. However, Schedule III of the Companies Act, 2013 (2013 Act) notified on 6 April 2016, requires ‘Revenue from Operations’ to be disclosed inclusive of excise duty.

The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) issued a notification on behalf of SEBI, on 20 September 2016, which clarifies that companies should follow a uniform approach in their revenue disclosures. Accordingly, ‘Income from Operations’ may be disclosed inclusive of excise duty, instead of net of excise duty, as specified in the 2013 Act.

This clarification is based on the guidance in the SEBI circular(CIR/CFD/FAC/62/2016) dated 5 July 2016, which stated that ‘in case of any technical difficulty in the interpretation of any specific item in the formats or implementation of this circular while publishing the financial results, the listed entities shall be guided by the relevant provisions of the Companies (Indian Accounting Standards) Rules, 2015 (Ind AS Rules)/Companies (Accounting Standards) Rules, 2006 (AS Rules) and Schedule III to the 2013 Act and may make suitable modifications, as applicable’.

The clarification is also consistent with the view proposed by the Ind AS Transition Facilitation Group (ITFG) of the Institute of Chartered Accountants of India (ICAI) in its 4th bulletin. The ITFG -4, based on guidance in Ind AS 18- Revenue and Schedule III of the 2013 Act, considered excise duty to be a liability of the manufacturer, which forms part of the cost of production. Accordingly, revenue should be presented as a gross amount inclusive of excise duty, which should therefore be reflected as an expense.


Saturday, April 2, 2016

Channel Stuffing and Spring Loading - Jargon of the Accounting World


 Image result for terminology 


Channel Stuffing:
Is a practice where the company tries to bolster revenue artificially by granting unsustainable or improper inducements to wholesalers and customers to get them to take its products.A channel stuffing company may also book revenue by transferring goods to an entity that is not totally separate.

Channel stuffing has been prevalent in the pharmaceutical industry over the years.
 

Spring Loading:When one company acquires another, there is usually a period of several weeks between the announcement of the deal and the actual date at which the acquired company becomes part of the acquirer. In that interim, the acquirer may find a way to book higher level of costs and lower revenue at the company being acquired.

This process, which takes place before the acquired company’s financial statements merge with those of the acquirer, is intended to suppress the profitability of the firm being bought,   solely for the interim period. Once part of the acquirer, the costs and revenue of the acquired firm return to more normal levels, enabling its profit to surge once it can benefit the bottom line of the acquirer.

Courtesy:http://www.nytimes.com/2016/03/29/business/dealbook/valeants-accounting-error-a-warning-sign-of-bigger-problems.html?smprod=nytcore-iphone&smid=nytcore-iphone-share&_r=0

Thursday, February 4, 2016

How-to IFRS Series..(3/5)

How-to distinguish source of funds as a 
 Debt or Equity?

Let’s begin reading this article by knowing the definition of Financial Instruments. A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

The essence of the definition lies in contract which we generally understand as a transaction having all the three characteristics: agreement between two or more parties; for an economic consideration and legally enforceable.

The definition then highlights financial assets, financial liabilities and equity instrument. Assets, liabilities, equity instrument reminds us of the balance sheet. For example, in credit sales transaction, the entity which sold the goods has a financial asset – trade receivable – while the purchaser has to account for a financial liability – trade payable. Another example is when the entity sources finance by issuing ordinary equity shares. The entity that subscribes to the shares accounts for a financial asset – an investment in shares – while the issuer has to account for equity instrument – equity share capital.
We can now gauge that accounting for financial instruments is how we account for trade receivables, investment in shares, investment in bonds (financial assets), how we account for trade payables, borrowings (financial liabilities) , how we account for equity share capital (equity instrument). Derivatives contract are also part of financial instruments and accounting for derivatives will be discussed in another article.
There are various steps to follow as to how to account for financial instruments starting with initial measurement, classification and subsequent measurement.
This article will emphasize on the accounting for equity instruments and financial liability. Both arise when the entity receives money in return for issuing a financial instrument.

Debt v/s Equity

It is of prime importance for any entity to rightly classify the money raised as either a financial liability (debt) or an equity instrument. This distinction impacts the measurement of profit as interest cost associated with debt will be charged to the statement of profit and loss, thus reducing the reported profit of the entity, while dividends on equity shares are an appropriation of profit rather than an expense. This distinction is equally important to the users of the financial statements as it directly affects the calculation of debt-equity ratio – a key measure to assess the financial risk of the entity.



Question asked to the Issuer?

When raising finance on the transaction date the issuer has to consider replying to the question: Does he have any sort of obligation which he needs to repay on the transaction? If the issuer has an obligation to repay, the transaction will be classified as financial liability (debt) as opposed to being an equity instrument. Therefore, the issue of debenture creates a financial liability as the monies have to repaid, while the issue of ordinary equity shares creates an equity instrument. Equity instrument is formally defined in the standard as any contract evidencing a residual interest in the assets of an entity after deducting all its liabilities.

Equity Instruments

Equity is initially measured at fair value minus any issue costs. They are not remeasured. Any change in the fair value of the shares is not recognized by the entity. Equity dividends are paid at the discretion of the entity and are accounted for as reduction in the retained earnings.
·        Case Study 1: Accounting for the issue of equity
Neupane Ltd. issues 10,000 Re.1 ordinary shares for cash of Rs.2.50 each. Issue costs are Rs. 1,000.
Solution: Ordinary shares are issued increasing the ownership interest in the net assets of the company. There is no obligation on the part of the issuer to repay the money received. The issue costs are written off against the share premium. Accounting for issue of equity shares can be reflected as under:
Cash a/c …………………………………………Dr                       24,000
   To Equity Share Capital …………………………………                      10,000
   To Share Premium……………………………………….                       14,000

Financial Liabilities

Where an instrument contains an obligation to repay it is classified as financial liability. Further, financial liabilities are categorized either at amortized cost or at fair value through profit and loss (FVTPL)

Financial Liabilities at amortized cost

Most of financial liabilities are categorized and accounted for at amortized cost. All amortized cost liabilities are initially measured at fair value minus transaction costs.
The accounting for financial liability at amortized cost means that the effective interest rate (EIR) of the liability will be recorded as interest cost in the statement of profit and loss. The liability will not be revalued at any reporting date. The effect of EIR accounting is that each year the liability will increase by the amount of interest charged to the profit and loss account and decrease by the amount of actual interest paid.
·        Case Study 2: Accounting for financial liability at amortized cost
Pasupati Ltd. raises money by issuing 100 zero coupon bonds at par of Rs. 100 each. The bonds will be redeemed after three years at a premium of 1,910. The effective interest rate (EIR) calculated is 6%.
Solution: The bond is a zero coupon bond meaning that no actual interest is paid during the tenor of the bond. Even though no interest is paid there will still be interest charge to profit and loss in this borrowing. The premium paid Rs.1,910 on maturity represents the interest charge. It will not be appropriate to charge the interest each year on the straight line basis as this would ignore the compounding nature of interest, thus effective interest rate is calculated. The presentation of liability at amortized cost is summarized below:


Opening Balance
Plus Interest @ EIR 6% - P&L a/c
Less Actual interest paid
Closing Balance – Balance Sheet
Year 1
10,000
600
0
10,600
Year 2
10,600
636
0
11,236
Year 3
11,236
674
11,910
0

Financial Liabilities at Fair Value Through Profit and Loss (FVTPL)

Financial liabilities are only categorized at Fair Value Through Profit and Loss (FVTPL) if they are held for trading or the entity designates at fair value. The entity can use the option to designate a financial liability at fair value only if by doing so it significantly reduces the ‘accounting mismatch’ which would otherwise arise from measuring the assets or liabilities or recognizing the gains and losses on them on different bases or financial assets and financial liabilities are managed together and its performance is evaluated on a fair value basis as per the investment strategy. If a financial liability contains one or more embedded derivatives that require separation then that financial liability may be designated at FVTPL.
Financial liabilities categorized as FVTPL are initially measured at fair value and transaction costs are written off to the statement of profit or loss.
The accounting of Financial Liability at FVTPL is to increase the financial liability by EIR interest cost and reduce by actual interest paid. It is then revalued at each reporting date at fair value and any unrealized gains or loss because of revaluation is recognized in the statement of profit or loss. The fair value at the reporting date will be its market price, or if not known then, the present value of the future cash flows discounted at current market interest rate.
·        Case Study 3: Accounting for financial liability at FVTPL
Prime Ltd. issued a three year 7% debentures on January 1, 2012 of the value Rs.30,000 when the EIR of the debenture was also 7%. The debentures will be redeemed at par. The liability is categorized at FVTPL. At the end of first accounting period in the market interest rate is at 8% and at the end of second accounting period the interest rate in the market has fallen down to 6%.
Solution: The initial measurement is at fair value of Rs.30,000 received and there are no transaction costs. If transaction costs then these would be expensed in the statement of profit and loss.
With the coupon rate and EIR at the end of first accounting period being the same, i.e. 7%, the carrying value of the liability will be same Rs. 30,000. This is because financial liability will be increased by an amount of EIR (30,000*7% = 2,100) and reduced by actual interest paid (30,000*7% = 2,100).
The liability is at FVTPL, this carrying value as at December 31, 2012 has to be revalued. The fair value of the liability at this date will be the present value using the market rate of 8% of the remaining 2 years cash flows:
Payment dates
Cash flow

8%discount factor

Present value of cash flow
31-12-2013
2,100
X
0.9259
=
  1,945
31-12-2014
32,100
X
0.8573
=
27,520
Fair value of the liability at 31-12-2014
29,465

The reduction in the carrying value of the liability of Rs. 535 is considered as unrealized profit in the statement of profit and loss. If higher discount rate was not because of general rise in market rates but the credit risk of the entity, then the gain is recognized in Other Comprehensive Income (OCI).

Date
Opening Balance
Plus EIR on opening balance
Less Actual interest paid (7%*30,000)
Carrying Value of Liability at reporting date
Fair Value of Liability at reporting date
Unrealized Gain/Loss to P&L a/c
31-12-2012
30,000
2,100
(2,100)
30,000
29,465
535
31-12-2013
29,465
2,357
(2,100)
29,722
30,283
(283)
31-12-2014
30,283
1,817
(2100)
30,000
Repaid
Repaid

The accounting principle is based on what we have always known for debt, when interest rate increases the fair value of debt decreases and when interest rate decreases value of debt rises.