Presentation of Financial Instruments - Liability vs. Equity

Because investors rely on accounting information to make their investment decisions, it is important for accounting information to present items according to their substance, and not merely their legal form. Some financial instruments have the legal form of equity but are in substance, liabilities.

Under IFRS the issuer should classify the instrument, or its component parts, as a financial liability or equity in accordance with the ‘substance’ of contractual arrangement on initial recognition, and the definitions of financial liability and an equity instrument. The classification is made at the date of issue and is not revised later.

The critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation on one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) or to exchange another financial instrument with the holder under potentially unfavorable conditions.

Note that a restriction on the ability of the issuer to satisfy an obligation, such as lack of access to foreign currency to repay a foreign currency loan, does not negate the existence of liability.

Scenario: An obligation to pay dividends

IStaR Ltd. issues 100,000 preference shares with a fixed rate of dividend @ 7% at par for INR 1 million. According to the terms of the contract, the directors of IStaR Ltd. have to compulsorily pay dividend following the date of issue.

Solution:

In substance, ‘preference share’ issue is a liability as IStaR Ltd. has a contractual obligation to deliver cash to the holder of preference shares by way of dividends. In short, only if the distributions to the holders of preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, then the shares are equity instruments.

Every Business is the Same Inside – Part 1

This post is abstracts of a chapter from a book What the CEO wants you to know? Understanding business in today’s times has been a myth and this book ensures that for being a successful businessperson you know what it takes to conduct a business. The fundamentals of business understanding stands true in every environment and economy.

Business acumen requires understanding the building blocks of money making. Think back to how you learned physics or chemistry. First you had to understand the parts of an atom: electrons, protons and neutrons. Once you understood the parts and how they interact, you were ready to develop your knowledge. It’s the same in business.

When 2 business people talk, whether or not they are in the same industry, whether or not they talk openly, they always try to gauge: Is her business making money? How is her business making money? Business people have an insatiable desire to cut through the complexity to the fundamental building blocks of money making.

Money making in business has three parts: cash generation, return on assets (a combination of margin and velocity) and growth. True businesspeople understand them individually as well as the relationships between them. Add consumers to these 3 parts of money making – cash generation, return on assets and growth – and you have the core, or nucleus, of any business.

Cash generation, margin, velocity, and return on assets, growth and customers: Everything else about a business emanates from this nucleus. Does the business generate cash and earn a good return on assets? Are we retaining customers? Is the business growing? If so, common sense tells you that the business is doing well. A large, complex company will eventually falter if core is not right.

Don’t let your formal education or the size of your company obscure the simplicity of your business. Cut through the nucleus of the business. If your business shows deterioration in one or more of the basic components of money making, use common sense to fix it. If you do, you are on your way to thinking and acting like a true businessperson and a successful CEO!

Cash generation: cash gives you the ability to stay in business. It is a company’s oxygen supply. Lack of cash, decreasing cash or consumption of cash spells trouble, even if the other elements of money making – such as margin and velocity – look good. Most people understand cash on a small scale, in their own everyday life. If the bills are due before the salary arrives, what happens? In a large company, however some people loose sight of cash. Many think that’s the responsibility of the finance department. But everybody in the company must be aware that his actions use cash or generate cash. A sales rep that negotiates for a 30 day payment from a customer versus 45 days is cash wise. A plant manager whose poor scheduling results in the accumulation of a lot of inventory consumes cash. Smart businesspeople know that generating cash can help grow the business. Invested wisely, cash improves the company’s money making ability. There’s a psychological component to cash: when a company has its own cash rather than borrowed money, senior managers are more inclined to make bold investments that have greater potential for rewards.

The latter part on margin, velocity, return on assets, growth and customers will follow in my next article.

Day 1 Profit or Loss

The transaction price (i.e. consideration given towards assets and consideration received towards liabilities) is normally the best evidence of the fair value of a financial instrument at initial recognition.

An exception to this general rule exists where the fair value of an instrument is evidenced by comparison with other observable current market transactions in the same instrument (i.e. without modification or repackaging) or based on valuation technique whose variables include only data from observable markets.

Where there is strong, market-based evidence of the fair value of the financial instrument, the instrument is initially recognized at the fair value and an immediate day 1 profit and loss may arise. Using unobservable inputs to calculate a fair value different to the transaction price on day 1 involves a high degree of subjectivity and therefore this cannot be used as fair value on initial recognition of a financial instrument. In such a situation, the instrument is initially recognized at its transaction price, and consequently day 1 profit and loss would not be recognized upon initial recognition.

When day 1 profit and loss has not been recognized for the above reason and therefore included in the initial carrying amount, IAS 39 requires a gain or loss to be recognized subsequently only to the extent that it arises from a change in a factor (including time) that market participants would consider in setting a price.

However, the standards do not further elaborate what constitutes a change in a factor. Since there is little clarity as to when this “hidden” day 1 profit and loss can be recognized, this day 1 profit and loss could be deferred until all market inputs become observable, or instead released over the life of the instrument on a systematic basis.

For example, a bank charges a fee for issuing a short-term loan commitment that is higher than the bank’s estimate of the fair value of the loan commitment using its proprietary valuation model. The bank does not recognize an upfront gain but measures the derivative loan commitment at the transaction price.

The bank should recognize in earnings observable changes in the fair value of the derivative that have occurred subsequent to initial recognition that a market participant would consider in setting a price. Unless the bank can demonstrate objectively that the fair value of the derivative loan commitment has changed due to changes in mortgage rates or other factors (that would qualify as observable market data) occurring subsequent to initial recognition, the bank should not recognize a change in the fair value of the loan commitment as profit.

To illustrate, the bank received `500,000 to issue the loan commitment and the bank’s proprietary model valued the commitment at `300,000. The bank would initially recognize a derivative liability at `500,000 equivalent to the cash received. Assume that at the next measurement date, adjusting the valuation model for observable market changes, the estimated value was `200,000 (a decrease of `100,000 from the previous model estimate). The bank reduces the derivative liability to `400,000 and recognizes `100,000 as a fair value movement in earnings. The initial difference of `200,000 (`500,000 minus `300,000) can be either amortized or deferred (and recognized in profit or loss at the maturity date if the loan commitment was not exercised, or included in the carrying amount of the loan and recognized in profit or loss through the effective interest rate, if the loan commitment was exercised).

In accordance with IFRS 7 Financial Instruments: Disclosures, if such day 1 profit and loss exists, an entity shall disclose by class of financial instrument a) its accounting policy for recognizing that difference in profit or loss to reflect a change in factors (including time) that market participants would consider in setting a price and b) the aggregate difference yet to be recognized in profit or loss at the beginning and end of the period and a reconciliation of changes in the balance of this difference.

IFRS 7 – FAIR VALUE HIERARCHY

As a part of the disclosure requirements for fair value measurements, an entity should classify the financial instruments measured at fair value using a ‘fair value hierarchy’ that reflects the significance of the inputs used in making the measurements. IFRS 7 consist of fair value hierarchy in its required disclosures to increase the comparability and consistency.

A new standard “Fair Value Measurements” by IASB is expected to come by April 2011 on the lines of Statement No. 157 or ASC 820 of the US GAAP as a part of joint project of FASB and IASB.

As per existing IFRS 7, the fair value hierarchy has three different levels:

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. A quoted price in an active market provides the most reliable evidence of fair value and should be used to measure fair value whenever available, except as follows:

• In some situations, a quoted price in an active market might not represent fair value at the measurement date. That might be the case if, for example, significant events (announcements) occur after the close of a market but before the measurement date. If the quoted price is adjusted for new information, the adjustment renders the fair value measurement a lower level measurement.

Level 1 input instrument is listed equities, listed debt, listed investment fund.

Level 2 inputs are observable for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. Level 2 inputs include the following:

• Quoted prices for identical or similar assets or liabilities in markets that are not active.
• Quoted prices for similar assets or liabilities in active markets.
• Inputs other than quoted prices that are observable for the asset or liability (e.g. yield curves).
• Inputs that are derived principally from or corroborated by observable market data by correlation or other means (market-corroborated inputs).

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs should reflect the reporting entity’s own assumptions which assumptions the market participants would use in pricing the asset or liability (including assumptions about risk). The reporting entity’s own data used to develop unobservable inputs should be adjusted if information is reasonably available without undue cost and effort that indicates that market participants would use different assumptions.

As explained above, the level is determined by the inputs used to determine fair value. There are some misperceptions about how to determine where in the hierarchy a fair value measurement falls. For example, one misperception is that the valuation model utilized affects the level determination. Instead, one must analyze the inputs used in the model to determine their significance and the hierarchy level.

The inputs with the most significance will determine the level of the fair value measurement.

Another misperception is that the higher the risk, the lower in the hierarchy the fair value measurement falls. For example, if the counterparty credit risk is high and that input is significant, it has been assumed that the fair value measurement is Level 3. However, the correct answer is based on how observable the counterparty credit risk is. If an entity’s credit-risk rating is published and/or available from many sources, that would be considered observable and a Level 2 input, therefore making the fair value measurement a Level 2. However, if the risk rating is determined using data gathered by a client and not from observable sources, the input would be Level 3.

Example:

An instrument for which there is currently no active market. A consensus pricing mechanism is used to determine its fair value.

The consensus pricing mechanism gets its inputs from market participants. These participants may determine the fair value by using models with unobservable inputs. The quotes that the participants provide to the consensus pricing mechanism are not binding bids and are not necessarily supported by prices from observable current market transactions.

Response:

Usually level 3 unless evidence can be provided that the quotes are supported by observable transactions or inputs, in which case, level 2.

Revised Schedule VI

http://mca.gov.in/Ministry/pdf/Schedule_VI_28feb2011.pdf

The Ministry of Corporate Affairs (MCA) has issued a revised Schedule VI to the Companies Act 1956 on the 28th February 2011.

This revised Schedule VI has nothing to do with the converged Indian Accounting Standards (IND AS) as notified by the Ministry earlier. The Schedule has been framed been framed as per the existing non-converged Indian Accounting Standards (AS) notified under the Companies (Accounting Standards) Rules, 2006. This Schedule will apply to all the companies registered with ROC for the financial statements to be prepared for the financial year 2010 - 2011 and onwards.

The highlights of the Revised Schedule VI is as follows:

1. Applies to all companies following non-converged Indian Accounting Standards

2. No possibility of conflict between Accounting Standard and Schedule VI as on modification of accounting standards prescribed under the companies act, Schedule VI would stand modified accordingly

3. The disclosure requirement of revised Schedule VI are in addition to that required by Accounting Standards prescribed under the Companies Act

4. All disclosures required by Companies Act to be made in notes to accounts

5. Cross-referencing each line item with notes and vice versa required

6. Unit of measurement selected to used uniformly in financial statements

7. One year comparatives required

8. Classification of all assets and liabilities into current and non-current

9. Definition of current asset and current liability in line with converged Ind AS 1 or IAS 1

10. Nature and purpose of each reserve to be stated only for those aggregated under “Other Reserves”

11. Debit balance of Profit and Loss Account to be shown as negative figure in Surplus

12. Reserve and Surplus balance can be negative

13. Period and amount of continuing default as on the balance sheet date in repayment of loans and interest to be separately specified

14. Dividends proposed to be disclosed

15. Expenses in Statement of Profit and Loss to be classified based on nature of expenses

16. Gain / Loss on foreign currency transaction to be separated into finance costs and other expenses

17. Disclosure of quantitative details of goods diluted.

Please click on the link above for a copy of the Revised Schedule VI.

Govt deferred IFRS implementation

http://economictimes.indiatimes.com/news/economy/finance/govt-deferred-ifrs-implementation/articleshow/7578251.cms

A news article in Economic Times - 26 February 2011 which states that as per the press note of MCA dated 25-02-2011 the implementation of IFRS will miss the deadline of 1-April-2011 but is sure to come some day......;). Hopeful still coz the headline reads deferred and not cancelled!!!!

The government has deferred the implementation of international financial reporting standards , acknowledging industry demand to extend the April 1 deadline to remove ambiguities on taxation issues. The decision has come as a relief for over 300 large companies, which were to submit their financials as per the global accounting standards, commonly called IFRS.

The ministry of corporate affairs on Friday said it remained committed to the transition as it notified 35 accounting standards that are in line with IFRS. “After detailed consultations, it was felt necessary that industry should be given some more time to prepare themselves to converge their accounts,” said a corporate affairs ministry official. A ministry release said the convergence will happen in a phased manner after various tax-related issues are resolved.

Finance Minister Pranab Mukherjee is likely to provide clarity on the taxation aspect in his budget speech. “The date of implementation of converged Indian accounting standards will be notified at a later date,” said the release. Sections of the industry had criticised the April 1 dateline for reasons including a lack of preparedness and confusion over taxation matters. Industry’s concerns were discussed in detail recently when corporate affairs minister Murli Deora met representatives of business chambers to understand their concerns. Accounting experts welcomed the move. “The fact that the standards are being notified is a step in the right direction. It gives certainty to the convergence and shows our commitment on the same,” said Jamil Khatri, partner at consulting firm KPMG.

Prime minister Manmohan Singh had made a commitment towards the alignment of Indian accounting standards with IFRS at the G20 summit in 2009. Thereafter, the ministry of corporate affairs came up with a road map for the convergence, wherein companies part of BSE Sensex and NSE Nifty, those listed on overseas stock exchanges, apart from companies with a networth of above Rs 1,000 crore were to converge with IFRS from April 1, 2011. Since November last year, there has been a demands from the industry and certain regulators that India should not rush into the convergence .

Chairman of the public accounts committee of Parliament Murli Manohar Joshi in November 2010 urged the prime minister to delay the rollout by at least two years, saying the country needs to enter into a dialogue with other countries to modify the proposed norms to suit local practices. Thereafter, the PM had advised the corporate affairs ministry to hold a fresh round of discussions with companies that were to follow the IFRS standards from April. Concerns got even larger when industry body FICCI asked the ministry to defer the April 1 deadline, citing lack of clarity on tax issues. Although the government has deferred the rollout date, it will go ahead with the notification of the new set of accounting standards. “While remaining committed to the IFRS convergence scheme, we want to make sure that approach is kept sound and full proof,” said another government official, requesting anonymity. Corporate affairs ministry is set to introduce the new Companies Bill the current Parliament session, the passage of which is critical to the smooth convergence with IFRS.

Indian Accounting Standards Converged with IFRS Notified

http://pib.nic.in/newsite/erelease.aspx?relid=70248

Finally, we have a press note specifiying that the Converged Indian Accounting Standards (IND AS) are notified by MCA dated 25-February 2011. The IND ASs (35 standards notified) are converged with International Financial Reporting Standards (IFRS). The verbatim script of the press note as released by the MCA is as under:

QUOTE

Reliable, consistent and uniform financial reporting is important part of good corporate governance practices worldwide in order to enhance the credibility of the businesses in the eyes of investors to take informed investment decisions. In pursuance of G-20 commitment given by India, the process of convergence of Indian Accounting Standards with IFRS has been carried out in Ministry of Corporate Affairs through wide ranging consultative exercise with all the stakeholders. Thirty five Indian Accounting Standards converged with International Financial Reporting Standards (henceforth called IND AS) are being notified by the Ministry and placed on the website. . These are: IND ASs 1, 2, 7, 8, 10, 11, 12, 16, 17, 18, 19, 20, 21, 23, 24, 27, 28, 29, 31, 32, 33, 34, 36, 37, 38, 39, 40, 101, 102, 103, 104, 105, 106, 107 and 108. The Ministry of Corporate Affairs will implement the IFRS converged Indian Accounting Standards in a phased manner after various issues including tax related issues are resolved with the concerned Departments. It would be ensured that the implementation of the converged standards in a phased manner is smooth for the stakeholders. The date of implementation of the IND AS will be notified by the Ministry at a later date.

The Press Release and IND ASs are available on the Ministry’s website at www.mca.gov.in .

Ministry of Corporate Affairs, Government of India

New Delhi February 25, 2011

RCJ/VL/PT-Corporate Affairs Press Note

(Release ID :70248)

UNQUOTE

IFRS in India from 1-April-2011

Source: http://pib.nic.in/newsite/erelease.aspx?relid=69867 Ministry of Corporate Affairs 17-February, 2011 16:56 IST Convergence of Indian Accounting Standards with International Financial Reporting Standards

Availability of essential financial information about a company to its shareholders and other stakeholders in accordance with internationally accepted financial norms is considered as an integral and important part of good corporate governance. To ensure this and to implement the G-20 commitment to achieve a single set of high quality global accounting standards, the Government has taken a decision to achieve convergence of Indian Accounting Standards with IFRS in a phased manner beginning with April, 2011 in accordance with the roadmap suggested by Core Group and Technical Groups set up by the Government. India's commitment to the policy of 'convergence' of Indian Accounting Standards with IFRS would allow it to consider local economic conditions and environment while preparing converged accounting standards, thus duly and adequately safeguarding the interests of Indian companies/enterprises. The convergence with IFRS would provide reliable and comparable financial information to investors globally. Such converged accounting standards also aim at bringing more transparency in financial matters, thus seek to protect the interests of investors and improve standards of good corporate governance. They would also enhance the global competitiveness of Indian Industry. The ICAI has been taking a number of measures for capacity building through various training programmes and workshops etc. The Industry Associations have also been conducting various seminars and conferences to get acquainted with various practical issues involved in the convergence process. The Industry has always expressed a feeling of readiness on the matter. The concerns expressed by them at various stages have been redressed through issue of suitable clarifications. Press Releases were also issued from time to time for awareness of all stakeholders. Such Press Releases are available on this Ministry's website at www.mca.gov.in. The proposed converged accounting standards have been prepared after following a detailed consultative exercise through issue of exposure drafts by Accounting Standards Board (ASB) of Institute of Chartered Accountants of India (ICAI), examination of comments received thereon and thereafter consideration of such standards by ICAI, National Advisory Committee on Accounting Standards (NACAS) and thereafter by Central Government (MCA) in consultation with M/o Law and Justice. The revised Schedule VI (Format of Financial Statements), Schedule XIV (Depreciation Rate) and proposed converged accounting standards are ready and are proposed to be notified shortly.