12.

26 FINANCIAL REPORTING

UNIT 2:
CLASSIFICATION AND MEASUREMENT OF FINANCIAL
ASSETS AND FINANCIAL LIABILITIES

2.1 INITIAL RECOGNITION AND SUBSEQUENT

MEASUREMENT
All financial assets and financial liabilities are recognised at their fair values upon initial
recognition. Classification of the financial assets and financial liabilities drives their subsequent
measurement.

2.2 FINANCIAL ASSETS: KEY ELEMENTS TO DETERMINE

CLASSIFICATION
Key essential elements that determine classification of financial assets are:
(A) Business model (BM) test:
• An entity's business model refers to how an entity manages its financial assets in
order to generate cash flows.

 An entity's business model for managing financial assets is a matter of fact

and not merely an assertion. It is typically observable through the activities
that the entity undertakes to achieve the objective of the business model and
an entity will need to use judgement when it assesses its business model for
managing financial assets.
 This assessment is not determined by a single factor or activity. Instead,
the entity must consider all relevant evidence that is available. Such
Factors relevant evidence includes, but is not limited to:
determining (a) how the performance of business model and the financial assets held
BM within that business model are evaluated & reported to the entity's key
management personnel;
(b) the risks that affect the performance of the business model (and the
financial assets held within that business model) and, in particular, the way
in which those risks are managed; and
(c) how managers of the business are compensated (for example,
whether the compensation is based on the fair value of the assets
managed or on the contractual cash flows collected).

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.27

 An entity's business model is determined at a level that

reflects how groups of financial assets are managed together
to achieve a particular business objective and not based on
management's intentions for an individual instrument.
Level of Accordingly, this condition is not an instrument-by-instrument
aggregation approach to classification and should be determined on a
of assets higher level of aggregation.
for  However, a single entity may have more than one business
determining model for managing its financial instruments. Consequently,
BM classification need not be determined at the reporting entity
level. For example, an entity may hold a portfolio of
investments that it manages in order to collect contractual
cash flows and another portfolio of investments that it
manages in order to trade to realise fair value changes.

 Entity's business model determines whether cash flows will

result from collecting contractual cash flows, selling financial
assets or both. Consequently, this assessment is not
Determining
performed on the basis of scenarios that the entity does not
basis of
reasonably expect to occur, such as so-called 'worst case' or
realisation
'stress case' scenarios.
of
contractual  For example, if an entity expects that it will sell a particular
cash flows portfolio of financial assets only in a stress case scenario, that
scenario would not affect the entity's assessment of the
business model for those assets if the entity reasonably
expects that such a scenario will not occur.

If cash flows are realised in a way that is different from the entity's
expectations at the date that the entity assessed the business
model (for example, if the entity sells more or fewer financial
Difference assets than it expected when it classified the assets), that does not
in actual give rise to a prior period error in the entity's financial statements
realisation nor does it change the classification of the remaining financial
from BM assets held in that business model (ie those assets that the entity
recognised in prior periods and still holds) as long as the entity
considered all relevant information that was available at the time
that it made the business model assessment.

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• Financial assets held for trading:

Financial assets held for trading are defined as those that:
(a) are acquired or incurred principally for the purpose of sale or repurchase in the near
term;
(b) on initial recognition are part of a portfolio of identified financial instruments that are
managed together and for which there is evidence of a recent actual pattern of short-
term profit-taking; or
(c) are derivatives (except for those that are financial guarantee contracts or are
designated effective hedging instruments).
Trading generally reflects active and frequent buying and selling, and financial instruments
held for trading are normally used with the objective of generating a profit from short-term
fluctuations in price or a dealer's margin.
Illustration 1
An entity holds investments to collect their contractual cash flows. The funding needs of
the entity are predictable and the maturity of its financial assets is matched to the entity's
estimated funding needs.
The entity performs credit risk management activities with the objective of minimising credit
losses. In the past, sales have typically occurred when the financial assets' credit risk has
increased such that the assets no longer meet the credit criteria specified in the entity's
documented investment policy. In addition, infrequent sales have occurred as a result of
unanticipated funding needs.
Reports to key management personnel focus on the credit quality of the financial assets
and the contractual return. The entity also monitors fair values of the financial assets,
among other information.
Evaluate the business model.
Solution

- Although the entity considers, among other information, the financial assets' fair
values from a liquidity perspective (ie the cash amount that would be realised if the
entity needs to sell assets), the entity's objective is to hold the financial assets in
order to collect the contractual cash flows.

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- Sales would not contradict that objective if they were in response to an increase in the
assets' credit risk, for example if the assets no longer meet the credit criteria specified
in the entity's documented investment policy. Infrequent sales resulting from
unanticipated funding needs (eg in a stress case scenario) also would not contradict
that objective, even if such sales are significant in value.
Hence the business model of the company is to collect contractual cash flows and not
realisation from sale of financial assets.
*****
Illustration 2
An entity's business model is to purchase portfolios of financial assets, such as loans.
Those portfolios may or may not include financial assets that are credit impaired.

If payment on the loans is not made on a timely basis, the entity attempts to realise the
contractual cash flows through various means—for example, by contacting the debtor by
mail, telephone or other methods. The entity's objective is to collect the contractual cash
flows and the entity does not manage any of the loans in this portfolio with an objective of
realising cash flows by selling them.
In some cases, the entity enters into interest rate swaps to change the interest rate on
particular financial assets in a portfolio from a floating interest rate to a fixed interest rate.
Evaluate the business model.
Solution
The objective of the entity's business model is to hold the financial assets in order to collect
the contractual cash flows. The same analysis would apply even if the entity does not
expect to receive all of the contractual cash flows (eg some of the financial assets are
credit impaired at initial recognition).
Moreover, the fact that the entity enters into derivatives to modify the cash flows of the
portfolio does not in itself change the entity's business model.
*****
Illustration 3
Entity B sells goods to customers on credit. Entity B typically offers customers up to 60
days following the delivery of goods to make payment in full. Entity B collects cash in

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accordance with the contractual cash flows of trade receivables and has no intention to
dispose of the receivables.
Evaluate the business model.
Solution
Entity’s B objective is to collect contractual cash flows from trade receivables and
therefore, trade receivables meet the business model test for the purpose of classifying the
financial assets at amortised cost.
*****
Illustration 4
An entity anticipates capital expenditure in a few years. The entity invests its excess cash
in short and long-term financial assets so that it can fund the expenditure when the need
arises. Many of the financial assets have contractual lives that exceed the entity's
anticipated investment period.
The entity will hold financial assets to collect the contractual cash flows and, when an
opportunity arises, it will sell financial assets to re-invest the cash in financial assets with a
higher return. The managers responsible for the portfolio are remunerated based on the
overall return generated by the portfolio.

Evaluate the business model.

Solution
The objective of the business model is achieved by both collecting contractual cash flows
and selling financial assets. The entity will make decisions on an ongoing basis about
whether collecting contractual cash flows or selling financial assets will maximise the return
on the portfolio until the need arises for the invested cash.
In contrast, consider an entity that anticipates a cash outflow in five years to fund capital
expenditure and invests excess cash in short-term financial assets. When the investments
mature, the entity reinvests the cash in new short-term financial assets. The entity
maintains this strategy until the funds are needed, at which time the entity uses the
proceeds from the maturing financial assets to fund the capital expenditure. Only sales that
are insignificant in value occur before maturity (unless there is an increase in credit risk).
The objective of this contrasting business model is to hold financial assets to collect
contractual cash flows.
*****

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.31

Illustration 5
An entity has a business model with the objective of originating loans to customers and
subsequently selling those loans to a securitisation vehicle. The securitisation vehicle
issues instruments to investors. The originating entity controls the securitisation vehicle
and thus consolidates it.
The securitisation vehicle collects the contractual cash flows from the loans and passes
them on to its investors. In the consolidated balance sheet, loans continue to be
recognised because they are not derecognised by the securitisation vehicle.

Evaluate the business model.

Solution
The entity originating loans to customers has the objective of realising contractual cash
flows on the loan portfolio only through sale to securitisation vehicle. However, the
consolidated group originates loans with the objective of holding them to collect the
contractual cash flows.
- Hence, the consolidated financial statements provide for a business model with the
objective of collecting contractual cash flows by holding to maturity.
- And in separate financial statements of the entity originating loans to customers,
business model is to collect cash flows through sale only.
*****
Illustration 6
A financial institution holds financial assets to meet liquidity needs in a 'stress case'
scenario (eg, a run on the bank's deposits). The entity does not anticipate selling these
assets except in such scenarios. The entity monitors the credit quality of the financial
assets and its objective in managing the financial assets is to collect the contractual cash
flows. The entity evaluates the performance of the assets on the basis of interest revenue
earned and credit losses realised.
However, the entity also monitors the fair value of the financial assets from a liquidity
perspective to ensure that the cash amount that would be realised if the entity needed to
sell the assets in a stress case scenario would be sufficient to meet the entity's liquidity
needs. Periodically, the entity makes sales that are insignificant in value to demonstrate
liquidity.
Evaluate the business model.

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Solution
The objective of the entity's business model is to hold the financial assets to collect
contractual cash flows. The analysis would not change –
- If during a previous stress case scenario the entity had sales that were significant in
value in order to meet its liquidity needs; or
- Recurring sales activity that is insignificant in value is not inconsistent with holding
financial assets to collect contractual cash flows; or
- If the entity is required by its regulator to routinely sell financial assets to demonstrate
that the assets are liquid, and the value of the assets sold is significant, the entity's
business model is not to hold financial assets to collect contractual cash flows.
Whether a third party imposes the requirement to sell the financial assets, or that
activity is at the entity's discretion, is not relevant to the analysis.
In contrast, if an entity holds financial assets to meet its everyday liquidity needs and
meeting that objective involves frequent sales that are significant in value, the objective of
the entity's business model is not to hold the financial assets to collect contractual cash
flows.
*****
(B) Contractual cash flows characteristics test:
Ind AS 109.4.1.1(b) requires an entity to classify a financial asset on the basis of its
contractual cash flow characteristics if the financial asset is held –
i. within a business model whose objective is to hold assets to collect contractual cash
flows; or
ii. within a business model whose objective is achieved by both collecting contractual
cash flows and selling financial assets.
To do so, an entity is required to determine whether the asset's contractual cash flows
are solely payments of principal and interest on the principal amount outstanding for
the currency in which the financial asset is denominated.
• The key characteristics of cash flows to test if they are solely payments of principal
and interest are as follows:

 Principal is the fair value of the financial asset at initial recognition.

What is
principal?  However, that principal amount may change over the life of the
financial asset (for example, if there are repayments of principal).

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Contractual cash flows that are solely payments of principal and

interest on the principal amount outstanding are consistent with
a basic lending arrangement. An originated or a purchased
financial asset can be a basic lending arrangement irrespective of
whether it is a loan in its legal form.
 In a basic lending arrangement, consideration for the time value
of money and credit risk are typically the most significant
elements of interest.
 However, in such an arrangement, interest can also include –
 consideration for other basic lending risks (for example, liquidity
risk);
 costs (for example, administrative costs) associated with holding
the financial asset for a particular period of time; and
 profit margin that is consistent with a basic lending arrangement.
 In extreme economic circumstances, interest can be negative if,
for example, the holder of a financial asset either explicitly or
Components
of ‘interest implicitly pays for the deposit of its money for a particular period
element’ of time (and that fee exceeds the consideration that the holder
receives for the time value of money, credit risk and other basic
lending risks and costs).
 However, contractual terms that introduce exposure to risks or
volatility in the contractual cash flows that is unrelated to a basic
lending arrangement, such as exposure to changes in equity
prices or commodity prices, do not give rise to contractual cash
flows that are solely payments of principal & interest.
 Leverage is a contractual cash flow characteristic of some
financial assets, that increases the variability of the contractual
cash flows with the result that they do not have the economic
characteristics of interest. Stand-alone option, forward and swap
contracts are examples of financial assets that include such
leverage. Thus, such contracts cannot be said to have
contractual cash flows that are only payments of principal &
interest and hence, cannot be subsequently measured at
amortised cost or fair value through other comprehensive
income.

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• Following are examples of contractual terms that result in contractual cash flows that
are solely payments of principal and interest on the principal amount outstanding:
(a) a variable interest rate on a financial instrument, where this rate consists of
consideration for –
- time value of money,
- credit risk associated with the principal amount outstanding during a
particular period of time (the consideration for credit risk may be determined
at initial recognition only, and so may be fixed); and
- other basic lending risks and costs, as well as a profit margin.
This is because this variable interest rate is only to provide the lender with a
return through ‘interest’ based on present market factors and no other form of
return on the principal amount of the financial instrument. So, it has
characteristics of return similar to one on a basic lending arrangement and thus,
meets definition of contractual cash flows that are solely payments of principal
and interest.
(b) a contractual term that permits the issuer (ie the debtor) to prepay a debt
instrument or permits the holder (ie the creditor) to put a debt instrument back to
the issuer before maturity and the prepayment amount substantially represents
unpaid amounts of principal and interest on the principal amount outstanding,
which may include reasonable additional compensation for the early termination
of the contract;
Reasonable additional compensation’ implies that the party choosing to exercise
its option to terminate the contract compensates the other party.
Exception
Some prepayment options could result in other party being forced to accept
negative compensation – e.g. the lender receives an amount less than the unpaid
amounts of principal and interest if the borrower chooses to prepay.
Earlier, these instruments were measured at FVTPL. However, now after
amendment, such financial assets could be measured at amortised cost or at
FVOCI if they meet the other relevant requirements of Ind AS 109.
To be eligible for the exception, the fair value of the prepayment feature would
have to be insignificant on initial recognition of the asset. If this is impracticable
to assess based on the facts and circumstances that existed on initial recognition
of the asset, then the exception would not be available. Also financial assets
prepayable at current fair value would be measured at FVTPL. The same would
apply if the prepayment amount includes the fair value cost to terminate a

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hedging instrument if the amount is inconsistent with the current Ind AS 109
prepayment rules. (The measurement principles given here have been explained
in detail in the subsequent sections).
(c) a contractual term that permits the issuer or the holder to extend the contractual
term of a debt instrument (ie an extension option) and the terms of the extension
option result in contractual cash flows during the extension period that are solely
payments of principal and interest on the principal amount outstanding, which
may include reasonable additional compensation for the extension of the
contract.
Illustration 7
Instrument A is a bond with a stated maturity date. Payments of principal and interest
on the principal amount outstanding are linked to an inflation index of the currency in
which the instrument is issued. The inflation link is not leveraged and the principal is
protected.
Evaluate the Contractual cash flows characteristics test
Solution
The contractual cash flows are solely payments of principal and interest on the
principal amount outstanding. Linking payments of principal and interest on the
principal amount outstanding to an unleveraged inflation index resets the time value of
money to a current level. In other words, the interest rate on the instrument reflects
'real' interest. Thus, the interest amounts are consideration for the time value of
money on the principal amount outstanding.
However, if the interest payments were indexed to another variable such as the
debtor's performance (eg the debtor's net income) or an equity index, the contractual
cash flows are not payments of principal and interest on the principal amount
outstanding (unless the indexing to the debtor's performance results in an adjustment
that only compensates the holder for changes in the credit risk of the instrument, such
that contractual cash flows are solely payments of principal and interest). That is
because the contractual cash flows reflect a return that is inconsistent with a basic
lending arrangement.
*****
Illustration 8
Instrument F is a bond that is convertible into a fixed number of equity instruments of
the issuer. Analyse the nature of cash flows.

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Solution
The holder would analyse the convertible bond in its entirety. The contractual cash
flows are not payments of principal and interest on the principal amount outstanding
because they reflect a return that is inconsistent with a basic lending arrangement; ie
the return is linked to the value of the equity of the issuer.
*****
Illustration 9
Instrument H is a perpetual instrument but the issuer may call the instrument at any
point and pay the holder the par amount plus accrued interest due.

Instrument H pays a market interest rate but payment of interest cannot be made
unless the issuer is able to remain solvent immediately afterwards. Deferred interest
does not accrue additional interest. Analyse the nature of cash flows.

Solution
The contractual cash flows are not payments of principal and interest on the principal
amount outstanding. That is because the issuer may be required to defer interest
payments and additional interest does not accrue on those deferred interest amounts.
As a result, interest amounts are not consideration for the time value of money on the
principal amount outstanding.
If interest accrued on the deferred amounts, the contractual cash flows could be
payments of principal and interest on the principal amount outstanding.
*****
Illustration 10

Instrument D is loan with recourse and is secured by collateral. Does the collateral
affect the nature of contractual cash flows?
Solution

The fact that a loan is collateralised (since with recourse) does not in itself affect the
analysis of whether the contractual cash flows are solely payments of principal and
interest on the principal amount outstanding. The collateral is only a security to
recover dues.
*****

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.37

Illustration 11
Instrument G is a loan that pays an inverse floating interest rate (ie the interest rate
has an inverse relationship to market interest rates). Analyse the nature of cash flows.
Solution
Here, interest on the instrument has an inverse relationship to the market rate of
interest. Hence, it is unlike a basic lending arrangement which normally comprises of
interest payable on any funds lent, as a consideration for the time value of money,
credit risk and profit margin normally existing in such arrangements. This
arrangement with an inverse floating interest rate provides the lender with a return
which may be higher or lower to the market rate of interest and hence, is not
necessarily a consideration for the time value of money on the principal amount
outstanding.
Thus, these do not represent contractual cash flows that are solely payments of
principal and interest on the principal amount outstanding.
*****

2.3 FINANCIAL ASSETS: CLASSIFICATION – OVERALL

CONCEPT
Categorisation of financial assets (FA) is determined based on the business model that
determines how cash flows of the financial asset are collected and the contractual cash flow
characteristics; and can be:
(a) Measured at Amortised cost
(b) Measured at fair value through comprehensive income (FVOCI)
(c) Measured at fair value through profit or loss (FVTPL).
• As per Ind AS 109.4.1.1 – Except for financial assets designated as fair value through profit
or loss (refer Ind AS 109.4.1.5), an entity shall classify financial assets as subsequently
measured at amortised cost, fair value through other comprehensive income or fair value
through profit or loss on the basis of both:
(a) Entity's business model (BM) for managing the financial assets and
(b) Contractual cash flow characteristics of the financial asset.

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• Categorisation of financial assets has been broadly laid out in the below flow chart:

Financial Assets measured at

Amortised cost Fair value through

Other Fair value through
Comprehensive profit or loss
Income

If below conditions are met:

(a) FA is held with BM whose
objective is to hold financial FA are accounted at FVTPL if:
assets in order to collect
contractual cash flows (a) Any asset which is not
measured at amortised cost
(b) Contractual terms give rise and not measured at FVOCI; or
on specified dates to cash flows
that are solely payments of (b) If on initial recognition, any
principal and interest on the asset may irrevocably be
principal amount outstanding. designated as FVTPL if specific
criteria met.

 FA shall be measured at FVOCI if below

conditions are met:
(a) FA is held with BM whose objective is
achieved both by collecting contractual
cash flows and selling FA
(b) Contractual terms give rise on specified
dates to cash flows that are solely
payments of principal and interest on the
principal amount outstanding
 Any equity instruments for which the entity
makes an irrevocable election to carry at fair
value through OCI

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.39

• Exception to classification based on above criteria mentioned in para 109.4.1.1 –

Option to designate at fair value through profit or loss:
An entity may, at initial recognition, irrevocably designate a financial asset as measured at
fair value through profit or loss if doing so eliminates or significantly reduces a
measurement or recognition inconsistency (sometimes referred to as an 'accounting
mismatch') that would otherwise arise from measuring assets or liabilities or recognising
the gains and losses on them on different bases
The decision of an entity to designate a financial asset or financial liability as at fair
value through profit or loss is similar to an accounting policy choice (although, unlike
an accounting policy choice, it is not required to be applied consistently to all similar
transactions). When an entity has such a choice, paragraph 14(b) of IAS 8 requires the
chosen policy to result in the financial statements providing reliable and more relevant
information about the effects of transactions, other events and conditions on the entity's
financial position, financial performance or cash flows.

Financial Assets

Fair Value through

other comprehensive Fair Value through
Amortized Cost income profit or loss (FVTPL)
(FVTOCI)

SPPI Business
SPPI
Business Or Model Test
Or Held for Residual
Model Test Contractual - To collect
Contractual trading category
- To collect cash flow and
cash flow test
test - To sell

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1. Financial Assets at Amortised cost

• What is Amortised cost
♦ Amortised cost is the amount at which the financial asset is measured at initial
recognition minus the principal repayments, plus or minus the cumulative amortisation
using the effective interest method of any difference between that initial amount and
the maturity amount and, for financial assets, adjusted for any loss allowance.
♦ In applying effective interest method –
(a) Entity identifies fees that are an integral part of the effective interest rate of a
financial instrument. Fees that are an integral part of the effective interest rate of
a financial instrument are treated as an adjustment to the effective interest rate,
unless the financial instrument is measured at fair value, with the change in fair
value being recognised in profit or loss. In those cases, the fees are recognised
as revenue or expense when the instrument is initially recognised.
(b) Such fees adjusted in effective interest rate are then amortised over then
expected life of the instrument. However, a shorter period may be used if such
fee adjusted in effective interest rate pertains to such shorter period.
• Financial asset (FA) shall be classified at amortised cost if it meets both of following
criteria:
1. ‘Hold-to-collect’ business model test - Objective is to hold the financial asset in order
to collect contractual cash flows;
AND
2. ‘SPPI’ contractual cash flow characteristics test - Contractual terms give rise to
cash flows that are Solely Payments of Principal and Interest (SPPI) on the principal
amount outstanding.
• Examples of Financial assets classified and accounted for at amortised cost:
♦ Trade receivables
♦ Investments in government bonds (not held for trading)
♦ Investments in term deposits (at standard interest rates)
♦ Loan receivables with ‘basic’ features
Investment in Equity instrument can never be classified at amortized cost.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.41

Illustration 12 : Hold-to-collect’ business model test

An entity purchased a debt instrument for 1,00,000.
The instrument pays interest of 6,000 annually and has 10 years to maturity when purchased.
The entity intends to hold the asset to collect the contractual cash flows.
Evaluate the business model test.
Solution
Entity’s objective is to hold the asset to collect the contractual cash flows and not to sell the
assets before the maturity period.
Thus, the debt instrument would meet the ‘hold-to-collect’ business model test.
Illustration 13 : Hold-to-collect’ business model test
An entity purchased a debt instrument for 1,00,000.
The instrument pays interest of 6,000 annually and has 10 years to maturity when purchased.
The entity intends to hold the asset to collect the contractual cash flows.
Six years have passed and the entity is suffering a liquidity crisis and needs to sell the asset to
raise funds.
Evaluate the business model test.
Solution
Since the sale of financial assets was not expected on initial classification and therefore, does
not affect the classification (i.e. there is no retrospective reclassification).
Thus, the debt instrument would still meet the ‘hold-to-collect’ business model test.
Illustration 14 : SPPI or contractual cash flow test
SPPI test for loan with zero interest and no fixed repayment terms
Parent H Ltd. provides a loan to its Subsidiary S Ltd. The loan is classified as a current liability
in Subsidiary S’s financial statements and has the following terms:
– Interest free loan.
– No fixed repayment terms
– Repayable on demand of Parent H Ltd.
Does the loan meet the ‘SPPI’ or contractual cash flows characteristic test?
Solution
Yes. The terms for the repayment of the principal amount of the loan on demand satisfies the
criterion of SPPI.

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Illustration 15 : SPPI Test for loan with zero interest repayable in ten years
Parent H Ltd. provides a loan of INR 100 million to Subsidiary B. The loan has the following
terms:
– No interest
– Repayable in ten years.
Does the loan meet the ‘SPPI’ or contractual cash flows characteristic test?
Solution
Yes. The terms for the repayment of the principal amount of the loan on demand satisfies the
criterion of SPPI.
Illustration 16 : SPPI Test for loan with interest rate
Entity A Ltd. lends Entity B Ltd. INR 5 million for ten years, subject to the following terms:
– Interest is based on the prevailing variable market interest rate.
– Variable interest rate is capped at 10%.
– Repayable in ten years.
Does the loan meet the ‘SPPI’ or contractual cash flows characteristic test?
Solution
Contractual cash flows of both a fixed rate instrument and a floating rate instrument are
payments of principal and interest as long as the interest reflects consideration for the time
value of money and credit risk.
Therefore, a loan that contains a combination of a fixed and variable interest rate meets the
contractual cash flow characteristics test.
Illustration 17: Trade receivables – Amortised cost
H Ltd. makes sale of goods to customers on credit of 60 days. The customers are entitled to
earn a cash discount @ 5% per annum if payment is made before 60 days and an interest
@ 12% per annum is charged for any payments made after 60 days. Company does not have a
policy of selling its debtors and holds them to collect contractual cash flows.
Evaluate the financial instrument.
Solution
In the above case, since H Ltd. has a contractual right to receive cash flows from its customers
and therefore such trade receivable are financial assets for H Ltd.
Further, H Ltd. business model test to collect will satisfy as the objective is to hold its trade
receivable to collect contractual cash flows till the end of maturity period and such trade

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receivable recorded in books represents contractual cash flows that are solely payments of
principal and interest if paid beyond credit period.
Hence such trade receivables are classified at amortised cost.
*****
Illustration 18: Security Deposits – Amortized Costs
A Ltd. (the ‘Company’) has obtained the premises from B Ltd. on lease to carry on its business.
The lease contract period is 5 years. As per the lease agreement, A Ltd. has paid security
deposits to B Ltd. amounting to ` 10 Lac which is refundable after the expiry of lease
agreement.
How would such deposits be treated in books of the A Ltd. ?
Solution
In the above case, since A Ltd. has a contractual right to receive cash flows from its Lessor,
B Ltd. and therefore such security deposits receivable are financial assets for A Ltd.
Further, A Ltd. business model test to collect will be satisfied as the objective is to hold its
security deposits receivable to collect contractual cash flows till the end of maturity period. And
such trade receivable recorded in books represents contractual cash flows that are solely
payments of principal and interest.
Hence such security deposits receivables are classified at amortised cost.
*****
2. Financial Assets at Fair Value at Other Comprehensive Income
A. Accounting for debt instruments when it is classified as FVOCI
• Financial asset (FA) is measured at fair value through OCI (FVOCI) if it
meets both of following criteria:
1. ‘Hold-to-collect and sell’ business model test - Objective is achieved by
both holding the financial asset in order to collect contractual cash flows
and selling the financial asset i.e. Intention of the entity is to sell the
instrument before the investment matures.
AND
2. ‘SPPI’ contractual cash flow characteristics test - Contractual terms give
rise to cash flows that are Solely Payments of Principal and Interest (SPPI)
on the principal amount outstanding.
• Examples of FA classified and accounted for at FVOCI:
♦ Investments in government bonds where the investment period is likely to
be shorter than its maturity period.

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 12.44 FINANCIAL REPORTING

♦ Investments in corporate bonds where the investment period is likely to be

shorter than its maturity period.
Illustration 19 : Hold-to-collect’ or ‘hold-to-collect & sell’ business model test
Entity A has surplus funds – INR 50 million
A has not yet found suitable investment opportunity so it buys medium dated (5 year
maturity) high quality government bonds in order to generate interest income.
If a suitable investment opportunity arises before the maturity date, the entity will sell
the bonds and use the proceeds for the acquisition of a business operation. It is likely
that a suitable business opportunity will be found before maturity date.
Whether the investment opportunity will meet the ‘hold-to-collect’ or ‘hold-to-collect &
sell business model test?
Solution
Government bonds would not meet the ‘hold-to-collect’ business model test because it
is considered likely that the bonds will be sold well before their contractual maturity.
However, it is likely that such investment would meet the ‘hold-to-collect and sell’
business model test.
*****
B. Equity instrument when it is classified as FVOCI
♦ Ind AS 109 requires all equity investments to be measured at fair value. The
default approach is that all changes in fair value of instruments to be recognised
in profit or loss.
♦ However, for equity investments that are not held for trading, entities can make
an irrevocable election at initial recognition to classify the instruments as at
FVOCI, with all subsequent changes in fair value being recognised in other
comprehensive income.
♦ Under FVOCI category, fair value changes are recognised in OCI while dividends
are recognised in profit or loss.
♦ On disposal of the investment the cumulative change in fair value is required to
remain in OCI and is not recycled to profit or loss. However, entities have the
ability to transfer amounts between reserves within equity (i.e. between the
FVOCI reserve and retained earnings).
3. Financial Assets at profit and loss
• Fair value through profit or loss (FVTPL) is the residual category in Ind AS 109.
• Financial asset (FA) classified and measured at FVTPL if FA is:
♦ A held-for-trading financial asset

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.45

♦ A debt instrument that does not qualify to be measured at amortised cost or

FVOCI
♦ An equity investment which the entity has not elected to classify as at FVOCI
• Examples of Financial assets classified and accounted for at amortised cost:
♦ Derivatives that have not been designated in a hedging relationship, e.g.:
- Interest rate swaps
- Commodity futures/option contracts
- Foreign exchange futures/option contracts
♦ Investments in shares where the entity has not elected to account for at FVOCI.

2.4 FINANCIAL ASSETS: MEASUREMENT

Measurement of financial assets is driven by their classification and can be broadly explained
with the help of following diagrammatic presentation:

Measurement of Financial Assets

Initial measurement Subsequent measurement

Fair value – FA measured at FA measured at fair value

 Normally evidenced by the Amortised cost [FVTPL/ FVOCI]
transaction price (ie, fair value
of consideration given or
received)
 Where part of consideration is Fair value at initial recognition  Fair value determined periodically
for other than the financial  Principal repayments  For equity instruments – cost may
instrument, then entity shall  Cumulative interest using EIR* represent fair value in some situations
measure fair value of the
fi i li t t

 Interest. Dividend recorded in P&L For FVTPL/FVOCI debt instruments–

 Gains/ losses also recorded in P&L For FVOCI equity instruments –
 Interest / Dividend recorded in  Dividend recorded in P&L
P&L Gains / losses recorded in
 Gains/ losses also recorded in OCI
P&L

*EIR – Effective interest rate method

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Based on the above mentioned guidance, the decision tree for classification of financial
assets can be understood with the help of following flow chart:
Debt investments Derivative investments Equity investments

Contractual cash flows solely payments of principal

and interest

Pass Fail Fail Fail

Business model (BM) test Held for trading?

(at entity level)

1 Hold to collect 2 BM to collect Neither

contractual contractual 1 or 2 Yes No
cash flows cash flows
and sell asset
FVOCI option
Fair value option elected? elected?
No
No No Yes Yes

Amortised FVOCI (with FVPL FVOCI

cost recycling) (no recycling)

Accounting for transaction costs for the purpose of Effective interest rate method
Fees that are integral part of effective interest rate Fees that are not an integral part
of effective interest rate
(a) Origination fee received by the entity relating to (a) Fee charged for servicing a
the creation or acquisition of a financial asset. loan;
Such fees may include compensation for activities
such as evaluating the borrower's financial
condition, evaluating and recording guarantees,
collateral and other security arrangements,
negotiating the terms of the instrument, preparing
and processing documents and closing the
transaction. These fees are an integral part of
generating an involvement with the resulting
financial instrument.

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Fees that are integral part of effective interest rate Fees that are not an integral part
of effective interest rate
(b) Commitment fee received by the entity to (b) Commitment fee to originate
originate a loan where it is probable that the a loan when it is unlikely that
entity will enter into a specific lending a specific lending
arrangement. These fees are regarded as arrangement will be entered
compensation for an ongoing involvement with the into;
acquisition of a financial instrument. If the
commitment expires without the entity making the
loan, the fee is recognised as revenue on expiry.
(c) Origination fee paid on issuing financial asset (c) Loan syndication fee
measured at amortised cost. These fees are an received by an entity that
integral part of generating an involvement with a arranges a loan and retains
financial liability. An entity distinguishes fees and no part of the loan package
costs that are an integral part of the effective for itself (or retains a part at
interest rate for the financial liability from the same effective interest
origination fees and transaction costs relating to rate for comparable risk as
the right to provide services, such as investment other participants).
management services.

Illustration 20
ABC Bank gave loans to a customer – Target Ltd. that carry fixed interest rate @ 10% per
annum for a 5 year term and 12% per annum for a 3 year term. Additionally, the bank charges
processing fees @1% of the principal amount borrowed. Target Ltd borrowed loans as follows:
- 10 lacs for a term of 5 years
- 8 lacs for a term of 3 years.
Compute the fair value upon initial recognition of the loan in books of Target Ltd. and how will
loan processing fee be accounted?
Solution
The loans from ABC Bank carry interest @ 10% and 12% for 5 year term and 3 year term
respectively. Additionally, there is a processing fee payable @ 1% on the principal amount on
date of transaction. It is assumed that ABC Bank charges all customers in a similar manner and
hence this is representative of the market rate of interest.
Amortised cost is computed by discounting all future cash flows at market rate of interest.
Further, any transaction fees that are an integral part of the transaction are adjusted in the
effective interest rate and recognised over the term of the instrument.
Hence loan processing fees shall be reduced from the principal amount to arrive the value on
day 1 upon initial recognition.

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Fair value (5 year term loan) = 10,00,000 – 10,000 (1% x 10,00,000) = 9,90,000
Fair value (3 year term loan) = 8,00,000 – 8,000 (1% x 8,00,000) = 7,92,000.
Now, effective interest rate shall be higher than the interest rate of 10% and 12% on
5 year loan and 3 year loan respectively, so that the processing fees gets recognised as interest
over the respective term of loans.
*****
• Fair value
Fair value is the price that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date.
Per Ind AS 113.B2 – The objective of a fair value measurement is to estimate the price at
which an orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market conditions. A
fair value measurement requires an entity to determine all the following:
(a) the particular asset or liability that is the subject of the measurement (consistently with
its unit of account);
(b) for a non-financial asset, the valuation premise that is appropriate for the
measurement (consistently with its highest and best use);
(c) the principal (or most advantageous) market for the asset or liability.
(d) the valuation technique(s) appropriate for the measurement, considering the
availability of data with which to develop inputs that represent the assumptions that
market participants would use when pricing the asset or liability and the level of the
fair value hierarchy within which the inputs are categorised.
Now, we go on to understand the key aspects of initial and subsequent measurement along
with how classification of assets affects their measurement as explained in detail below:

2.5 FINANCIAL ASSETS: INITIAL MEASUREMENT

Fair value of a financial instrument at initial recognition is normally the transaction price (,ie,
fair value of consideration given or received).
• Instrument at off-market terms: Sometimes certain type of instruments may be
exchanged at off market terms (,ie, different from market terms for a similar instrument if
exchanged between market participants),
♦ For example, a long-term loan or receivable that carries no interest while similar
instruments if exchanged between market participants carry interest, then fair value
for such loan receivable will be lower from its transaction price owing to the loss of
interest that the holder bears. In such cases where part of the consideration given or

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received is for something other than the financial instrument, an entity shall measure
the fair value of the financial instrument.
♦ In the aforementioned example, the fair value of the long-term loan or receivable can
be measured as the present value of all future cash receipts discounted using the
prevailing market rate(s) of interest for a similar instrument (similar as to currency,
term, type of interest rate and other factors) with a similar credit rating. The additional
amount lent is an expense or a reduction of income unless it qualifies for recognition
as some other type of asset.
• Transaction costs:
♦ Transaction costs include fees and commission paid to agents (including employees
acting as selling agents), advisers, brokers and dealers, levies by regulatory agencies
and security exchanges, and transfer taxes and duties. Transaction costs do not
include debt premiums or discounts, financing costs or internal administrative or
holding costs.
♦ Any transaction costs incurred for acquisition of the financial asset are adjusted upon
initial recognition while determining fair value.
♦ If an entity originates a loan that bears an off-market interest rate (eg 5 per cent when
the market rate for similar loans is 8 per cent), and receives an upfront fee as
compensation, the entity recognises the loan at its fair value, ie net of the fee it
receives.
The decision tree for the aforementioned basis to be applied in establishing fair value
at initial recognition can be understood with following diagrammatic presentation:
Initial measurement

Instrument at market terms Instrument at off-market terms

Transaction price Determine fair value of financial instrument

If FV based on Level 1 input or valuation technique that Any other basis

uses only data from observable markets

Difference between FV & transaction price recognized

Difference between FV
as –
and transaction price
(i) asset (if it qualifies to be);
recognized in P&L
(ii) otherwise amortised to P&L

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• Specific transactions:
♦ Determining amortised cost for financial assets carrying floating rate of interest:
Per Application Guidance in Appendix B – B.5.4.5 – For floating rate financial
instruments, periodic re-estimation of cash flows to reflect movements in market rates
of interest alters the effective interest rate. To calculate the effective interest in each
relevant period, the effective interest rate is applied to the amortised cost of the asset
or liability at the previous reporting date. However, if the floating rate financial asset or
financial liability is initially recognised at an amount equal to the principal receivable
or payable on maturity, then this periodic re-estimation does not have a significant
effect on the carrying amount of the asset or liability.
Therefore, in such cases, for practical reasons the carrying amount of a floating rate
instrument would not generally need to be adjusted at each repricing date because the
impact would not generally be significant. In such case –
(a) Interest income or expense is recognised based on the current market rate.
(b) For a floating rate financial asset or financial liability that is initially recognised at
a discount or premium, the interest income or expense is recognised based on
the current market rate plus or minus amortisation or accretion of the discount or
premium.
♦ Modification in cash flows:
Per Application Guidance in Appendix B to Ind AS 109 – B.5.4.6 – If there is a change in
the timing or amount of estimated future cash flows (other than due to impairment) –
- It shall adjust the gross carrying amount of the financial asset or amortised cost
of a financial liability (or group of financial instruments) to reflect actual and
revised estimated contractual cash flows.
- The entity recalculates the gross carrying amount of the financial asset or
amortised cost of the financial liability as the present value of the estimated
future contractual cash flows that are discounted at the financial instrument’s
original effective interest rate (or credit-adjusted effective interest rate for
purchased or originated credit-impaired financial assets)
Then the carrying amount of the instrument (or group of financial instruments) is
adjusted in the period of change to reflect the actual and/or revised estimated cash
flows, with a corresponding gain or loss being recognised in profit or loss.
This approach to changes in estimated cash flows should apply to changing
prepayment expectations and other estimates of cash flows under the current terms of
the financial instrument but not to a renegotiation of the contractual terms of an
instrument.

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♦ Interest income after impairment recognition

If a financial asset or a group of similar financial assets has been written down as a
result of an impairment loss –
- Then interest income is thereafter recognised using the rate of interest used to
discount the future cash flows for the purpose of measuring the impairment loss.
- For assets measured at amortised cost, this interest rate would be the original
effective interest rate.
♦ Loans between group companies
(a) Repayable on demand:
As per Ind AS 113.47 – The fair value of a financial liability with a demand
feature - e.g. a demand deposit - is not less than the amount payable on
demand, discounted from the first date that the entity could be required to repay
the amount. Accordingly –
- The fair value of an interest-free loan liability of which the lender can
demand repayment of the face value at any time - i.e. a loan repayable on
demand - is not less than its face value.
- This would evenly apply from the perspective of the lender, since a market
participant acting in its best interest would be assumed to maximize value
by demanding immediate repayment and hence, the fair value shall be equal
to the amount payable on demand in books of lender.
(b) No fixed maturity:
If a loan has no fixed maturity date and is available in perpetuity, then in measuring
its fair value, discounting should reflect these terms because a market participant
acting in its best interest would not assume repayment of the loan. Similarly, the
asset holder or lender would also measure fair value that should reflect a market
participant's assumptions about the timing of the future cash flows.
In both of above cases–
- Any difference between the amount lent and the fair value of the instrument on
initial recognition is recognized as a gain or a loss unless it qualifies for
recognition as an asset or a liability.
- If a low-interest loan is given in anticipation of a right to receive goods or
services at favorable prices, then the right may be recognised as an asset if it
qualifies for recognition as an asset, for example: prepaid expenses, etc.

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♦ Demand deposits
The fair value of a financial liability with a demand feature - e.g. a demand deposit - is
not less than the amount payable on demand, discounted from the first date that the
entity could be required to repay the amount.
Hence, fair value of a demand deposit would be the amount payable on demand in
books of the party making the deposit (ie, holder of financial asset) as well as in books
of entity accepting the deposit (ie, bearer of financial liability).
Illustration 21: Deposits carrying off-market rate of interest:
Containers Ltd provides containers for use by customers for multiple purposes. The
containers are returnable at the end of the service contract period (3 years) between
Containers Ltd and its customers. In addition to the monthly charge, there is a security
deposit that each customer makes with Containers Ltd for ` 10,000 per container and
such deposit is refundable when the service contract terminates. Deposits do not
carry any interest. Analyse the fair value upon initial recognition in books of
customers leasing containers. Market rate of interest for 3 year loan is 7% per annum.
Solution
In the above case, lessee (ie, customers leasing the containers) make interest free
deposits, which are refundable at the end of 3 years. Now, this money if it was to lent
to a third party would fetch interest @ 7% per annum.
Hence, discounting all future cash flows (ie, ` 10,000)
Fair value on initial recognition = 10,000 / (1+0.07) 3 = 8,163.
Differential on day 1 = 10,000 – 8,163 = 1,837
The differential on day 1 shall be treated as follows:
- Scenario 1 – If fair valuation is determined using level 1 inputs or other
observable inputs, difference on day 1 recognised in profit or loss
- Scenario 2 – If fair valuation is determined using other inputs, difference on day 1
shall be recognised in profit or loss unless it meets definition of an asset or liability.
However, in case of security deposits level 1 fair value is not available. Therefore, in
the above case, the fair valuation is made based on unobservable inputs and hence
applying scenario 2, difference can be recognised as an asset if it meets the
definition. Now, since the lessee gets to use the containers in return for making an
interest free deposit plus monthly charges, the lost interest representing day 1
difference between value of deposit and its fair value is like ‘’prepaid lease rent’ and
can be recognised as such. Prepaid rent (ROU Asset) shall be charged off to profit or
loss in a straight lined manner as depreciation as per Ind AS 16.
*****

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.53

2.6 FINANCIAL ASSETS: SUBSEQUENT MEASUREMENT

• As defined in the flow chart above, the subsequent measurement of financial assets is
based on their classification as defined below:
(A) Assets measured at amortised cost
♦ Assets are classified as measured at amortised cost if below conditions are met
(as explained in paragraph – Financial assets: classification):
(a) Financial asset is held with BM whose objective is to hold financial assets in
order to collect contractual cash flows; and
(b) Contractual terms give rise on specified dates to cash flows that are solely
payments of principal and interest on the principal amount outstanding
♦ Where assets are classified as ‘amortised cost’ –
- They are initially measured at fair value as explained above
- Subsequently, the carrying value is adjusted for principal repayments and
interest accrued using effective interest rate, as explained earlier.
(B) Assets measured at fair value
♦ For assets not carried at amortised cost, they shall be carried at fair value. Such
assets can be categorised into –
i. Measured at fair value through other comprehensive income (FVOCI);
if–
(a) Following criteria are satisfied:
- FA is held with BM whose objective is achieved both by collecting
contractual cash flows and selling FA; and
- Contractual terms give rise on specified dates to cash flows that
are solely payments of principal and interest on the principal
amount outstanding
Or
(b) An equity instrument, which otherwise shall be carried at fair value
through profit or loss may be irrevocably recognised at fair value
through other comprehensive income,

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ii. Measured at fair value through profit or loss (FVTPL):

All assets not classified as ‘measured at amortised cost’ or ‘measured at fair
value through OCI’ shall be classified in this category.
Incomes and/ or expenses on assets measured at fair value shall be recognised as follows:

Measured at fair value (FV)

Interest/ Gains/ losses

dividend

FVTPL FVOCI – other than FVOCI – equity

equity instruments instruments

Realised/ Unrealised Realised FV Unrealised FV Realised/

FV gains/ losses gains/ losses gains/ losses Unrealised FV
gains/ losses

Recognised in Recognised in Recognised in

profit or loss profit or loss OCI

• If a financial instrument that was previously recognised as a financial asset is measured at

fair value through profit or loss and its fair value decreases below zero, it is a financial
liability measured at fair value.
• Equity instruments – where FV not determinable
♦ All investments in equity instruments and contracts on those instruments must be
measured at fair value. However, in limited circumstances, cost may be an appropriate
estimate of fair value. That may be the case if insufficient more recent information is
available to measure fair value, or if there is a wide range of possible fair value
measurements and cost represents the best estimate of fair value within that range
♦ Indicators that cost might not be representative of fair value include:
(a) a significant change in the performance of the investee compared with budgets,
plans or milestones.
(b) changes in expectation that the investee's technical product milestones will be
achieved.
(c) a significant change in the market for the investee's equity or its products or
potential products.
(d) a significant change in the global economy or the economic environment in which
the investee operates.

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(e) a significant change in the performance of comparable entities, or in the

valuations implied by the overall market.
(f) internal matters of the investee such as fraud, commercial disputes, litigation,
changes in management or strategy.
(g) evidence from external transactions in the investee's equity, either by the
investee (such as a fresh issue of equity), or by transfers of equity instruments
between third parties.
♦ The list above is not exhaustive. An entity shall use all information about the
performance and operations of the investee that becomes available after the date of
initial recognition. To the extent that any such relevant factors exist, they may
indicate that cost might not be representative of fair value. In such cases, the entity
must measure fair value.
♦ Cost is never the best estimate of fair value for investments in quoted equity
instruments (or contracts on quoted equity instruments).
Illustration 22: Accounting for transaction costs on initial and subsequent
measurement of a financial asset measured at fair value with changes through other
comprehensive income:
An entity acquires a financial asset for CU 100 plus a purchase commission of CU 2.
Initially, the entity recognises the asset at CU 102. The reporting period ends one day
later, when the quoted market price of the asset is CU 100. If the asset were sold, a
commission of CU 3 would be paid. How would transaction costs be accounted in books of
the entity?
Solution
- On that date, the entity measures the asset at CU 100 (without regard to the possible
commission on sale) and recognises a loss of CU 2 in other comprehensive income.
- If the financial asset is measured at fair value through other comprehensive income in
accordance with Ind AS 109.4.1.2A, the transaction costs are amortised to profit or
loss using the effective interest method.
*****
Illustration 23: Determining fair value upon initial measurement
The shareholders of Company C provide C with financing in the form of loan notes to
enable it to acquire investments in subsidiaries. The loan notes will be redeemed solely out
of dividends received from these subsidiaries and become redeemable only when C has
sufficient funds to do so. In this context, 'sufficient funds' refers only to dividend receipts
from subsidiaries. Analyse the initial measurement of loan notes.

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 12.56 FINANCIAL REPORTING

Solution
In this case –
Loan notes are repayable only then C earns returns in form of dividends from subsidiaries.
Hence, C cannot be forced to obtain additional external financing or to liquidate its
investments to redeem the shareholder loans. Consequently, the loan notes are not
considered payable on demand.
Accordingly –
- Loan notes shall be initially measured at their fair value (plus transaction costs), being
the present value of the expected future cash flows, discounted using a market-related
rate. The amount and timing of the expected future cash flows should be determined
on the basis of the expected dividend flow from the subsidiaries. Also, the valuation
would need to take into account possible early repayments of principal and
corresponding reductions in interest expense.
- Since the loan notes are interest-free or bear lower-than-market interest, there will be
a difference between the nominal value of the loan notes - i.e. the amount granted -
and their fair value on initial recognition. Because the financing is provided by
shareholders, acting in the capacity of shareholders, the resulting credit should be
reflected in equity as a shareholder contribution in C's balance sheet. Conversely, in
books of shareholders, the difference between amount invested and its fair value shall
be recorded as ‘investment in C Ltd’ being representative of the underlying
relationship between shareholders and C Ltd.
*****
Illustration 24 : Use of cost v/s fair value determination for equity instruments
Silver Ltd. has made an investment in optionally convertible preference shares (OCPS) of a
Company – Bronze Ltd. at ` 100 per share (face value ` 100 per share). Silver Ltd. has an
option to convert these OCPS into equity shares in the ratio of 1:1 and if such option not
exercised till end of 9 years, then the shares shall be redeemable at the end of 10 years at
a premium of 20%.
Analyse the measurement of this investment in books of Silver Ltd.
Solution
The classification assessment for a financial asset is done based on two characteristics:
i. Whether the contractual cash flows comprise cash flows that are solely payments of
principal and interest on the principal outstanding
ii. Entity’s business model (BM) for managing financial assets – Whether the Company’s
BM is to collect cash flows; or a BM that involves realisation of both contractual cash
flows & sale of financial assets;
In all other cases, the financial assets are measured at fair value through profit or loss.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.57

In the above case, the Holder can realise return either through conversion or redemption at
the end of 10 years, hence it does not indicate contractual cash flows that are solely
payments of principal and interest. Therefore, such investment shall be carried at fair value
through profit or loss. Accordingly, the investment shall be measured at fair value
periodically with gain/ loss recorded in profit or loss.
*****
Illustration 25 : Accounting for assets at amortised cost
A Ltd has made a security deposit whose details are described below. Make necessary
journal entries for accounting of the deposit in the first year and last year. Assume market
interest rate for a deposit for similar period to be 12% per annum.
Particulars Details
Date of Security Deposit (Starting Date) 1-Apr-20X1
Date of Security Deposit (Finishing Date) 31-Mar-20X6
Description Lease
Total Lease Period 5 years
Discount rate 12.00%
Security deposit (A) 10,00,000
Present value factor at the 5th year 0.567427

Solution
The above security deposit is an interest free deposit redeemable at the end of lease term
for ` 10,00,000. Hence, this involves collection of contractual cash flows and shall be
accounted at amortised cost.
Upon initial measurement –
Particulars Details
Security deposit (A) 10,00,000
Total Lease Period (Years) 5
Discount rate 12.00%
Present value factor of 5th year end 0.56743
Present value of deposit at beginning (B) 5,67,427
Prepaid lease payment at beginning (A-B) 4,32,573

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Journal Entries
Year – 1 beginning

Particulars Amount Amount

Security deposit A/c Dr. 5,67,427
Prepaid lease rent (ROU Asset) Dr. 4,32,573
To Bank A/c 10,00,000

Subsequently, every annual reporting year, interest income shall be accrued @ 12% per
annum and prepaid expenses shall be amortised on straight line basis over the lease term.
Year 1 end
Particulars Amount Amount
Security deposit A/c (5,67,427 x 12%) Dr. 68,091
To Interest income A/c 68,091
Depreciation (4,32,573 / 5 years) Dr. 86,515
To Prepaid lease rent (ROU Asset) 86,515

At the end of 5 th year, the security deposit shall accrue ` 10,00,000 and prepaid lease
expenses shall be fully amortised (i.e. depreciated as per Ind AS 116, this prepaid lease
rent would be shown as ROU asset). Journal entry for realisation of security deposit –
Particulars Amount Amount
Security deposit A/c Dr. 1,07,143
To Interest income A/c 1,07,143
Depreciation (4,32,573 / 5 years) Dr. 86,515
To Prepaid lease rent (ROU Asset) 86,515
Bank A/c Dr. 10,00,000
To Security deposit A/c 10,00,000

*****
Illustration 26 : Accounting for assets at FVTPL
A Ltd. invested in equity shares of C Ltd. on 15 th March for ` 10,000. Transaction costs
were ` 500 in addition to the basic cost of ` 10,000. On 31 March, the fair value of the
equity shares was ` 11,200 and market rate of interest is 10% per annum for a 10 year
loan. Pass necessary journal entries. Analyse the measurement principle and pass
necessary journal entries.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.59

Solution
The above investment is in equity shares of C Ltd and hence, does not involve any
contractual cash flows that are solely payments of principal and interest. Hence, these
equity shares shall be measured at fair value through profit or loss. Also, an irrecoverable
option exists to designate such investment as fair value through other comprehensive
income.
Journal Entries
Particulars Amount Amount
Upon initial recognition –
Investment in equity shares of C Ltd. Dr. 10,000
Transaction cost Dr. 500
To Bank A/c 10,500
(Being investment recognized at fair value plus transaction
costs upon initial recognition)
Profit and Loss A/c Dr. 500
To Transaction cost 500
(Being transaction cost incurred on assets measured at
FVTPL transferred to P&L A/c)

Subsequently –
Investment in equity shares of C Ltd. Dr. 1,200
To Fair value gain on financial instruments 1,200
(Being fair value gain recognized at year end in P&L)
Fair value gain on financial instruments Dr. 1,200
To Profit and Loss A/c 1,200
(Being fair value gain transferred to P&L A/c)

*****
Illustration 27: Accounting for assets at FVOCI
Metallics Ltd. has made an investment in equity instrument of a company – Castor Ltd. for
19% equity stake. Significant influence not exercised. The investment was made for
` 5,00,000 for 10,000 equity shares on 01 April 20X1. On 30 June 20X1 the fair value per
equity share is ` 45. The Company has taken an irrevocable option to measure such
investment at fair value through other comprehensive income.

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 12.60 FINANCIAL REPORTING

Solution
The Company has made an irrecoverable option to carry its investment at fair value
through other comprehensive income. Accordingly, the investment shall be initially
recognised at fair value and all subsequent fair value gains/ losses shall be recognised in
other comprehensive income (OCI).
Journal Entries
Particulars Amount Amount
Upon initial recognition –
Investment in equity shares of C Ltd. Dr. 5,00,000
To Bank a/c 5,00,000
(Being investment recognized at fair value plus
transaction costs upon initial recognition)
Subsequently –
Fair value loss on financial instruments Dr. 50,000
To Investment in equity shares of C Ltd. 50,000
(Being fair value loss recognised)
Fair value reserve in OCI Dr. 50,000
To Fair value loss on financial instruments 50,000
(Being fair value loss recognized in other comprehensive
income)

*****
Illustration 28: Accounting for assets at Amortised Cost
XYZ Ltd. is a company incorporated in India. It provides INR 10,00,000 interest free loan to
its wholly owned Indian subsidiary (ABC). There are no transaction costs.
How should the loan be accounted for, in the Ind AS financial statements of XYZ, ABC and
consolidated financial statements of the group?
Consider the following scenarios:
a) The loan is repayable on demand.
b) The loan is repayable after 3 years. The current market rate of interest for similar loan
is 10% p.a. for both holding and subsidiary.
c) The loan is repayable when ABC has funds to repay the loan.
Solution
Ind AS 109 requires that a financial assets and liabilities are recognized on initial
recognition at its fair value, as adjusted for the transaction cost. In accordance with Ind AS

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113 Fair Value Measurement, the fair value of a financial liability with a demand feature
(e.g., a demand deposit) is not less than the amount payable on demand, discounted from
the first date that the amount could be required to be paid.
Using the guidance, the loan will be accounted for as below in various scenarios:
Scenario (a)
Since the loan is repayable on demand, it has fair value equal to cash consideration
given. The parent and subsidiary recognize financial asset and liability, respectively, at the
amount of loan given. Going forward, no interest is accrued on the loan.
Upon repayment, both the parent and the subsidiary reverse the entries made at
origination.
Scenario (b)
Both parent and subsidiary recognize financial asset and liability, respectively, at fair value
on initial recognition. The difference between the loan amount and its fair value is treated
as an equity contribution to the subsidiary. This represents a further investment by the
parent in the subsidiary.
Accounting in the books of XYZ Ltd (Parent)
S. No. Particulars Amount Amount
On the date of loan
1 Loan to ABC Ltd (Subsidiary) Dr. 7,51,315
Deemed Investment (Capital Contribution) in ABC Ltd. Dr. 2,48,685
To Bank 10,00,000
(Being the loan is given to ABC Ltd and recognised at
fair value)
Accrual of Interest income
2 Loan to ABC Ltd Dr. 75,131
To Interest income 75,131
(Being interest income accrued) – Year 1
3 Loan to ABC Ltd Dr. 82,645
To Interest income 82,645
(Being interest income accrued) – Year 2
4 Loan to ABC Ltd Dr. 90,909
To Interest income 90,909
(Being interest income accrued) – Year 3

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On repayment of loan
5 Bank Dr. 10,00,000
To Loan to ABC Ltd (Subsidiary) 10,00,000
Accounting in the books of ABC Ltd (Subsidiary)
S. Particulars Amount Amount
No.
On the date of loan
1 Bank Dr. 10,00,000
To Loan from XYZ Ltd (Payable) 751,315
To Equity (Deemed Capital Contribution from XYZ 2,48,685
Ltd)
(Being the loan taken from XYZ Ltd and recognised
at Fair value)
Accrual of Interest
2 Interest expense Dr. 75,131
To Loan from XYZ Ltd (Payable) 75,131
(Being interest expense recognised) – Year 1
3 Interest expense Dr. 82,645
To Loan from XYZ Ltd (Payable) 82,645
(Being interest expense recognised) – Year 2
4 Interest expense Dr. 90,909
To Loan from XYZ Ltd (Payable) 90,909
(Being interest expense recognised) – Year 3
On repayment of loan
5 Loan from XYZ Ltd (Payable) Dr. 10,00,000
To Bank 10,00,000

Working Notes:-
1 Computation of Present value of loan
Rate 10%
Amount of Loan 10,00,000

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.63

Year 3
Present Value 7,51,315

2 Computation of interest for Year I

Present Value 7,51,315
Rate 10%
Period of interest - for 1 year 1
Closing value at the end of year 1 8,26,446
Interest for 1 st year 75,131

3 Computation of interest for Year 2

Value of loan as at the beginning of Year 2 8,26,446
Rate 10%
Period of interest - for 2 nd year 1
Closing value at the end of year 2 9,09,091
Interest for 2 nd year 82,645

4 Computation of interest for Year 3

Value of loan as at the beginning of Year 3 9,09,091
Rate 10%
Period of interest - for 3rd year 1
Closing value at the end of year 3 10,00,000
Interest for 3 rd year 90,909
Scenario (c)
Generally, a loan, which is repayable when funds are available, can’t be stated to be
repayable on demand. Rather, the entities need to estimate repayment date and determine its
measurement accordingly. If the loan is expected to be repaid in three years, its
measurement will be the same as in scenario (b).
In the Consolidated Financial Statements (CFS), the loan and interest income/expense will
get knocked-off as intra-group transaction in all three scenarios. Hence the above
accounting will not have any impact in the CFS. However, if the loan is in foreign currency,
exchange difference will continue to impact the statement of profit and loss in accordance
with the requirements of Ind AS 21.
*****

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2.7 FINANCIAL LIABILITIES: CLASSIFICATION

• Upon initial recognition, all financial liabilities are measured at fair value. Subsequently, per
Ind AS 109.4.2.1 – the classification of financial liabilities shall be as follows:
(A) Measured at amortised cost
(B) Measured at fair value through profit or loss:
♦ Liabilities that meet the definition of “held for trading”
♦ Contingent consideration recognized by an acquirer in a business combination
(C) Designated at fair value through profit or loss
(D) Other specific measurement basis (with changes recognized in profit or loss):
♦ financial liabilities that arise when a transfer of a financial asset does not qualify
for derecognition or when the continuing involvement approach applies: refer
paragraph 3.2.15 or 3.2.17 of Ind AS 109
♦ financial guarantee contracts and commitments to provide a loan at a below-
market interest rate are subsequently measured at higher of:
 the amount of the loss allowance, and
 the amount initially recognised less, when appropriate, the cumulative
amount of income recognised in accordance with the principles of Ind AS
115.”
Irrespective of above classification, any financial liabilities may be designated at fair
value through profit or loss if:
i. It eliminates or significantly reduces a measurement or recognition inconsistency
(‘accounting mismatch’) that would otherwise arise from measuring assets or
liabilities; or their gains on a different basis; or
ii. A group of financial liabilities and financial assets is managed and its performance is
evaluated on fair value basis, in accordance with a documented risk management or
investment strategy, and information about that group is provided internally on that
basis to the entity’s key management personnel.
• Financial assets and financial liabilities held for trading:
♦ Financial assets and liabilities held for trading are defined as those that:
(a) are acquired or incurred principally for the purpose of sale or repurchase in the
near term;

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(b) on initial recognition are part of a portfolio of identified financial instruments that
are managed together and for which there is evidence of a recent actual pattern
of short-term profit-taking; or
(c) are derivatives (except for those that are financial guarantee contracts or are
designated effective hedging instruments).
Trading generally reflects active and frequent buying and selling, and financial
instruments held for trading are normally used with the objective of generating a profit
from short-term fluctuations in price or a dealer's margin.
♦ In addition to derivatives that are not accounted for as hedging instruments, financial
liabilities held for trading include:
(a) obligations to deliver financial assets borrowed by a short seller (i.e. an entity
that sells financial assets it has borrowed and does not yet own);
(b) financial liabilities that are incurred with an intention to repurchase them in the
near term, such as quoted debt instruments that the issuer may buy back in the
near term depending on changes in fair value; and
(c) financial liabilities that are part of a portfolio of identified financial instruments
that are managed together and for which there is evidence of a recent pattern of
short-term profit-taking.
However, the fact that a liability is used merely to fund trading activities does not in
itself make that liability one that is held for trading.
Illustration 29 : Trade creditors at market terms
A Company purchases its raw materials from a vendor at a fixed price of ` 1,000 per
tonne of steel. The payment terms provide for 45 days of credit period, after which an
interest of 18% per annum shall be charged. How would the creditors be classified in
books of the Company?
Solution
In the above case, creditors for purchase of steel shall be carried at amortised cost,
ie, fair value of amount payable upon initial recognition plus interest (if payment is
delayed). Here, fair value upon initial recognition shall be the price per tonne, since
the transaction is at market terms between two knowledgeable parties in an arms-
length transaction and hence, the transaction price is representative of fair value.
*****
Illustration 30
An entity is about to purchase a portfolio of fixed rate assets that will be financed by
fixed rate debentures. Both financial assets and financial liabilities are subject to the
same interest rate risk that gives rise to opposite changes in fair value that tend to
offset each other. Provide your comments.

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Solution
The fixed rate assets provide for contractual cash flows and based on business model of
the entity, such fixed rate assets may be classified as ‘amortised cost’ (if entity collects
contractual cash flows) or fair value through other comprehensive income (FVOCI) (if
entity manages through collecting contractual cash and sale of financial assets).
In the absence of fair value option, the entity can classify the fixed rate assets as
FVOCI with gains and losses on changes in fair value recognised in other
comprehensive income and fixed rate debentures at amortised cost. However,
reporting both assets and liabilities at fair value through profit and loss, ie, FVTPL
corrects the measurement inconsistency and produces more relevant information.
Hence, it may be appropriate to classify the entire group of fixed rate assets and fixed
rate debentures at fair value through profit or loss (FVTPL).
*****

2.8 FINANCIAL LIABILITIES: MEASUREMENT

• Measurement of financial liabilities is driven by their classification upon initial recognition
as follows:

Financial liabilities measured at

Amortised cost: FVTPL liabilities: Fair value changes

Interest cost
(recognized using
effective interest
rate) Unrealised gain/loss Unrealised gain/loss Realised gain/loss
(other than change in for change in own (upon derecognition)
own credit risk) credit risk

Recorded in P&L upon

Recorded in P&L on a periodical basis Recorded in OCI derecognition of FL

• Specific transactions – restructuring of financial liability

If the terms of a financial liability are modified substantially, resulting in an extinguishment
of the old financial liability, then the old liability is derecognised and the restructured
financial instrument is treated as a new financial liability. If a modification of a financial
liability results in derecognition of the financial liability, then the effective interest rate of the
new financial liability is calculated based on the revised terms of the financial liability at the
date of the modification. In this case, any costs or fees incurred are recognised as part of

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the gain or loss on extinguishment and do not adjust the carrying amount of the new
liability.
If the exchange or modification is not accounted for as an extinguishment, then any costs
and fees incurred are recognised as an adjustment to the carrying amount of the liability.
For changes in future cash flows, the entity shall revised the amortised cost of the financial
liability to reflect revised future cash flows by discounting them to their present value at the
original effective interest rate. The difference between the carrying value and revised
amortised cost is recognized as a gain or loss in profit or loss.
Illustration 31: Issue of borrowings with fixed rate of interest
A Ltd has made a borrowing from RBC Bank for ` 10,000 at a fixed interest of 10% per
annum. Loan processing fees were additionally paid for ` 500 and loan is payable after 5
years in bullet repayment of principal. Details are as follows:
Particulars Details
Loan amount ` 10,000
Date of loan (Starting Date) 1-Apr-20X1
Date of repayment of principal amount 31-March-20X6
(Finishing Date)
Interest rate 10.00%
Interest charge Interest to be charged and paid yearly
Upfront fees ` 500
How would loan be accounted in books of A Ltd?
Solution
The loan taken by A Ltd shall be measured at amortised cost as follows:
- Initial measurement – At transaction price less processing fees
= 10,000 – 500 = 9,500
- Subsequently – interest to be accrued using effective rate of interest as follows:
Year end Opening Interest @ Repayment of Closing
balance 11.42% interest & principal balance
1 9,500 1,085 1,000 9,585
2 9,585 1,095 1,000 9,679
3 9,679 1,105 1,000 9,785
4 9,785 1,117 1,000 9,902
5 9,902 1,098* 11,000 -

* Difference due to approximation

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 12.68 FINANCIAL REPORTING

Computation of IRR
IRR would be the rate using which the present value of cash flow should come out to be
` 9,500 i.e. (` 10,000 less ` 500).
For this, we should first compute present value of cashflows using any two rates as follows:
Year Opening Repaym Closing PVF @ Present PVF @ Present
end balance ent/Cas balance 10% Value at 13% Value at
hflows 10% rate 13% rate
1 9,500 1,000 8,500 0.909 909 0.885 885
2 8,500 1,000 7,500 0.826 826 0.783 783
3 7,500 1,000 6,500 0.751 751 0.693 693
4 6,500 1,000 5,500 0.683 683 0.613 613
5 5,500 11,000 (5,500) 0.621 6,830 0.543 5,970*
10,000 8,945
*Difference is due to approximation
Taking 10% as discount rate, present value (PV) comes out to be ` 10,000.
If rate is increased by 3% over a base rate of 10%, PV decreases by ` 1,055 (i.e. ` 10,000
less ` 8945).
To decrease PV by ` 1,055, rate should be increased = 3%
To decrease PV by Re.1, rate should be increased = 3%
1,055
To decrease PV by ` 500, rate should be increased = 3% x (500/1,055)
= 1.42%
This would mean that the discount rate to get present value of cashflows equivalent to
` 9,500 should be 11.42% (i.e. 10% + 1.42%).
Illustration 32: Issue of borrowings with fixed rate of interest
A Ltd has made a borrowing from RBC Bank for ` 10,000 at a fixed interest of 12% per
annum. Loan processing fees were additionally paid for ` 500 and loan is payable 4 half-
yearly instalments of ` 2,500 each. Details are as follows:
Particulars Details
Loan amount ` 10,000
Date of loan (Starting Date) 1-Apr-20X1
Date of loan (Finishing Date) 31-March-20X3

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.69

Description of repayment Repayment of loan starts from 30-Sept-20X1 (To be paid

half yearly)
Installment amount ` 2,500
Interest rate 12.00%
Interest charge Interest to be charged quarterly
Upfront fees ` 500
How would loan be accounted in books of A Ltd?
Consider IRR is 16.60% p.a.
Solution
The loan taken by A Ltd shall be measured at amortised cost as follows:
- Initial measurement – At transaction price less processing fees
= 10,000 – 500 = 9,500
- Subsequently – interest to be accrued using effective rate of interest as follows:
Date Amount Re- Upfront Amount Days IRR Revised Loan
of Loan payment fees paid of Calcula- Interest Balance
Interest tion computed
1-Apr-20X1 10,000 - 500 - - 9,500 - -
30-Jun-20X1 - - - 300 90 (300) 389 9,589
30-Sep-20X1 - 2500 - 300 92 (2,800) 401 7,190
31-Dec-20X1 - - - 225 92 (225) 301 7,266
31-Mar 20X2 - 2500 - 225 90 (2,725) 297 4,838
30-Jun-20X2 - - - 150 91 (150) 200 4,888
30-Sep-20X2 - 2500 - 150 92 (2,650) 204 2,442
31-Dec-20X2 - - - 75 92 (75) 102 2,473
31-Mar-20X3 - 2500 - 75 91 (2,575) 102 -
IRR 16.60%

*****
Illustration 33: Accounting treatment of processing fees belonging to undisbursed
loan amount
X Ltd. had taken 6 year term loan in April 20X0 from bank and paid processing fees at the
time of sanction of loan.
The term loan is disbursed in different tranches from April 20X0 to April 20X6. On the date
of transition to Ind AS, i.e. 1.4.20X5, it has calculated the net present value of term loan

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disbursed upto 31.03.20X5 by using effective interest rate and proportionate processing
fees has been adjusted in disbursed amount while calculating net present value.
What will be the accounting treatment of processing fees belonging to undisbursed term
loan amount?
Solution
Processing fee is an integral part of the effective interest rate of a financial instrument and
shall be included while calculating the effective interest rate.
(a) Accounting treatment in case future drawdown is probable
It may be noted that to the extent there is evidence that it is probable that the
undisbursed term loan will be drawn down in the future, the processing fee is accounted
for as a transaction cost under Ind AS 109, i.e., the fee is deferred and deducted from
the carrying value of the financial liabilities when the draw down occurs and considered
in the effective interest rate calculations.
(b) Accounting treatment in case future drawdown is not probable
If it is not probable that the undisbursed term loan will be drawn down in the future, then
the fees is recognised as an expense on a straight-line basis over the term of the loan.
*****
Illustration 34: Accounting treatment of prepayment premium and processing fees for
obtaining new loan to prepay old loan
PQR Limited had obtained term loan from Bank A in 20X1-20X2 and paid loan processing
fees and commitment charges.
In May 20X5, PQR Ltd. has availed fresh loan from Bank B as take-over of facility i.e. the
new loan is sanctioned to pay off the old loan taken from Bank A. The company paid
prepayment premium to Bank A to clear the old term loan and paid processing fees to Bank
B for the new term loan.
Whether the prepayment premium and the processing fees both will be treated as
transaction cost (as per Ind AS 109, Financial Instruments) of obtaining the new loan, in
the financial statements of PQR Ltd?
Solution
(a) Accounting treatment of prepayment premium
Ind AS 109, provides that if an exchange of debt instruments or modification of terms is
accounted for as an extinguishment, any costs or fees incurred are recognised as part of
the gain or loss on the extinguishment in the statement of profit and loss.

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Since the original loan was prepaid, the prepayment would result in extinguishment of
the original loan. The difference between the CV of the financial liability extinguished
and the consideration paid shall be recognised in profit or loss as per Ind AS 109.
Accordingly, the prepayment premium shall be recognised as part of the gain or loss on
extinguishment of the old loan.
(b) Accounting treatment of Unamortised processing fee of old loan
Unamortised processing fee related to the old loan will also be required to be charged to
the statement of profit and loss.
(c) Accounting treatment of Processing fee for new loan
Transaction costs are “Incremental costs that are directly attributable to the acquisition,
issue or disposal of a financial asset or financial liability. An incremental cost is one that
would not have been incurred if the entity had not acquired, issued or disposed of the
financial instrument.”
It is assumed that the loan processing fees solely relates to the origination of the new
loan (i.e. does not represent loan modification/renegotiation fees). Hence, the
processing fees paid to avail fresh loan from Bank B will be considered as transaction
cost in the nature of origination fees of the new loan and will be included while
calculating effective interest rate as per Ind AS 109.
*****
Illustration 35: Accounting treatment of share held as stock in trade
A share broking company is dealing in sale/purchase of shares for its own account and
therefore is having inventory of shares purchased by it for trading.
How will these instruments be accounted for in the financial statements?
Solution
Ind AS 2, Inventories, states that this Standard applies to all inventories, except financial
instruments (Ind AS 32, Financial Instruments: Presentation and Ind AS 109, Financial
Instruments).
Accordingly, the principles of recognising and measuring financial instruments are governed
by Ind AS 109, its presentation is governed by Ind AS 32 and disclosures are in accordance
with Ind AS 107, Financial Instruments: Disclosures, even if these instruments are held as
stock-in trade by a company.
Further Ind AS 101, First-time Adoption of Indian Accounting Standards does not provide
any transitional relief from the application of the above standards.

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Accordingly, in the given case, the relevant requirements of Ind AS 109, Ind AS 32 and Ind
AS 107 shall be applied retrospectively.
*****
Difference between measurement requirements of financial liability and equity and their
comparison can be understood with the help of following diagrammatic presentation –

Contractual obligation to Non derivative contract to

deliver cash / financial deliver variable number of
asset equity shares

No Yes Yes No

Equity Equity
Liability Liability

Carried at Carried at
‘cost’ ‘cost’
Amortised cost Fair value

All transactions
recorded directly in - Cost recorded in income
equity statement
- Impact on net profit/ OCI

2.9 RECLASSIFICATION OF FINANCIAL ASSETS AND

FINANCIAL LIABILITIES
Per Ind AS 109.4.4.1 – An entity shall reclassify financial assets, only if the entity changes its
business model for managing those financial assets.
• Such changes are expected to be very infrequent. Such changes are determined by the
entity's senior management as a result of external or internal changes and must be
significant to the entity's operations and demonstrable to external parties. Accordingly, a
change in an entity's business model will occur only when an entity either begins or ceases
to perform an activity that is significant to its operations; for example, when the entity has
acquired, disposed of or terminated a business line.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.73

• Examples of a change in business model include the following:

(a) An entity has a portfolio of commercial loans that it holds to sell in the short term. The
entity acquires a company that manages commercial loans and has a business model
that holds the loans in order to collect the contractual cash flows. The portfolio of
commercial loans is no longer for sale, and the portfolio is now managed together with
the acquired commercial loans and all are held to collect the contractual cash flows.
(b) A financial services firm decides to shut down its retail mortgage business. That
business no longer accepts new business and the financial services firm is actively
marketing its mortgage loan portfolio for sale.
• Accounting for reclassification of financial assets:
♦ A change in the objective of the entity's business model must be effected before the
reclassification date. For example, if a financial services firm decides on 15 February
to shut down its retail mortgage business and hence must reclassify all affected
financial assets on 1 April (ie the first day of the entity's next reporting period), the
entity must not accept new retail mortgage business or otherwise engage in activities
consistent with its former business model after 15 February.
♦ If an entity reclassifies any financial asset, it must do so prospectively from
reclassification date.
♦ The entity shall not restate any previously recognised gains, losses (including
impairment gains or losses) or interest.
• Following are not changes in business model:
(a) a change in intention related to particular financial assets (even in circumstances of
significant changes in market conditions);
(b) the temporary disappearance of a particular market for financial assets;
(c) a transfer of financial assets between parts of the entity with different business models.
• Following changes in circumstances are not reclassifications:
(a) an item that was previously a designated and effective hedging instrument in a cash
flow hedge or net investment hedge no longer qualifies as such;
(b) an item becomes a designated and effective hedging instrument in a cash flow hedge
or net investment hedge; and
(c) changes in measurement for a financial instrument, if the entity takes credit derivative
that is measured at fair value through profit or loss to manage the credit risk of all, or
part of such financial instrument and consequently, the underlying financial instrument
is also designated at fair value through profit or loss.

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• Financial liabilities are not permitted to be reclassified.

Illustrative examples:
♦ Case 1: Amortised cost to FVTPL
- It is measured at fair value on reclassification date.
- Any gain or loss arising from difference between the previous amortised cost of
the financial asset and fair value is recognised in profit or loss.
Illustration 36
Bonds for ` 1,00,000 reclassified as FVTPL. Fair value on reclassification is ` 90,000.
Pass the required journal entry.
Solution
Particulars Amount Amount
Bonds at FVTPL Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at amortised cost 1,00,000

*****
♦ Case 2: Amortised cost to FVOCI
- It is measured at fair value on reclassification date.
- Any gain or loss arising from difference between the previous amortised cost of
the financial asset and fair value is recognised in other comprehensive income
- Effective interest rate and measurement of expected credit losses are not
adjusted as a result of reclassification.
Illustration 37
Bonds for ` 1,00,000 reclassified as FVOCI. Fair value on reclassification is ` 90,000.
Pass the required journal entry.
Solution
Particulars Amount Amount
Bonds at FVOCI Dr. 90,000
OCI (Loss on reclassification) Dr. 10,000
To Bonds at amortised cost 1,00,000

*****

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♦ Case 3: FVTPL to Amortised cost

- It is measured at fair value on reclassification date and this fair value becomes
the new gross carrying amount. Effective interest rate is computed based on this
new gross carrying amount.
- Any gain or loss arising from difference between the previous amortised cost of
the financial asset and fair value is recognised in profit or loss.
Illustration 38
Bonds for ` 100,000 reclassified as Amortised cost. Fair value on reclassification is
` 90,000. Pass the required journal entry.
Solution
Particulars Amount Amount
Bonds at Amortised cost Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at FVTPL 1,00,000

*****
♦ Case 4: FVTPL to FVOCI
- The financial asset continues to be measured at fair value.
- The effective interest rate is determined on the basis of fair value of asset at
reclassification date.
Illustration 39
Bonds for ` 100,000 reclassified as FVOCI. Fair value on reclassification is ` 90,000.
Pass the required journal entry.
Solution
Particulars Amount Amount
Bonds at FVOCI Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at FVTPL 1,00,000

*****

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♦ Case 5: FVOCI to Amortised cost

- The financial asset is measured at fair value on reclassification date.
- However, cumulative gain or loss previously recognised in other comprehensive
income (OCI) is removed from equity and adjusted against fair value of financial
asset at reclassification date.
- As a result, the financial asset is measured at reclassification date as if it had
always been measured at amortised cost. This adjustment affects OCI but does
not affect profit or loss and therefore, is not a reclassification adjustment.
- Effective interest rate and measurement of expected credit losses are not
adjusted as a result of reclassification.
Illustration 40
Bonds for ` 100,000 reclassified as Amortised cost. Fair value on reclassification is
` 90,000 and ` 10,000 loss was recognised in OCI till date of reclassification. Pass
required journal entry.
Solution
Particulars Amount Amount
Bonds at FVOCI Dr. 10,000
To OCI - Loss on reclassification 10,000
[Being loss recognized in OCI now reversed prior to
reclassification]
Bonds (Amortised cost) Dr. 1,00,000
To Bonds at FVOCI 1,00,000
[Being bonds reclassified from FVOCI to Amortised cost]

*****
♦ Case 6: FVOCI to FVTPL
- The financial asset continues to be measured at fair value.
- The cumulative gain or loss previously recognised in other comprehensive
income (OCI) is reclassified from equity to profit or loss as a reclassification
adjustment at the reclassification date.
Illustration 41
Bonds for ` 100,000 reclassified as FVTPL. Fair value on reclassification is ` 90,000.
Pass the required journal entry.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.77

Solution
Particulars Amount Amount
P&L - Loss on reclassification Dr. 10,000
To Bonds at FVTOCI 10,000
Bonds at FVTPL Dr. 90,000
To Bonds at FVOCI 90,000

*****

2.10 IMPAIRMENT
• Scope of impairment
An entity shall recognise a loss allowance for expected credit losses on the following:

(a) a financial asset that is measured at amortised cost

(b) a financial asset that is measured at fair value through other comprehensive income
(c) a lease receivable,
(d) a contract asset or a loan commitment; and
(e) a financial guarantee contract
• The impairment model does not apply to:

(a) All financial assets that are equity instruments (because these are measured either at
FVTPL or FVTOCI),
(b) Financial assets that are debt instruments and are measured as at FVTPL,
(c) Any other financial instrument measured as at FVTPL.
• What is a credit loss allowance?
♦ For financial assets, a credit loss is the present value of the difference between:
(a) the contractual cash flows that are due to an entity under the contract; and
(b) the cash flows that the entity expects to receive (i.e,, cash short falls) discounted
at original effective interest rate (or credit adjusted effective interest rate in case
of purchased or originated credit-impaired financial assets).

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 12.78 FINANCIAL REPORTING

♦ An entity shall estimate cash flows by considering all contractual terms of the financial
instrument (for eg.: prepayment, extension, call and similar options) through the
expected life of the financial instrument.
♦ The cash flows that are considered shall include cash flows from sale of collateral
held or other credit enhancements that are integral to the contractual terms. There is a
presumption that the expected life of the financial instrument can be estimated
reliably. In those rare cases when it is no possible to reliably estimate the expected
life of a financial instrument, the entity shall use the remaining contractual term of the
financial instrument.
• Different approaches for impairment of financial assets.
(a) General Approach
 The general approach requires an entity to recognise, at each reporting date, an
impairment loss allowance using either 12 month ECL or lifetime ECL.
 12 month ECL typically results in lower impairment since it focuses only on
probability of default (PD) within next 12 month period, as against PD over the
life of an instrument.
 The use of ECL depends on whether there has been a significant increase in
credit risk on the instrument since its initial recognition.
 This approach is applicable to all financial instruments covered by impairment
requirements of Ind AS 109, except instruments covered in the following two
approaches.
(b) Simplified Approach
 This approach does not require an entity to track changes in credit risk. Rather,
each entity recognises impairment loss allowance based on lifetime ECLs at each
reporting date, right from its initial recognition.
 The application of simplified approach is mandatory for trade receivables or any
contractual right to receive cash or another financial asset that result from
transactions that are within the scope of Ind AS 115.
(c) Purchased or originated credit-impaired (POCI) financial assets approach
 This approach is applicable to financial assets which are credit impaired on
purchase/origination.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.79

• What is 12-month expected credit losses and lifetime expected credit losses?
 Lifetime expected credit loss is the expected credit losses that result from all possible
default events over the expected life of a financial instrument.
 12-Month expected credit loss is the portion of the lifetime expected credit losses that
represent the expected credit losses that result from default events on a financial
instrument that are possible within the 12 months after the reporting date.
• How the entity determine whether it should apply 12-month ECL or lifetime ECL?
The decision tree to be applied in determining whether the entity needs to provide for
12-month expected credit losses or life time expected credit losses is applied as follows:

Three Stage Model for Impairment

Stage 1 Stage 2 Stage 3
Particular Initial Significant increase Credit
Recognition in credit risk Impaired
Credit Risk Low Moderate to High Significant
ECL Model 12 Month ECL Life-time ECL Life-time ECL
Interest on
Interest on gross Interest on net
Interest recognition gross
recognition carrying amount
recognition

• Determining whether credit risk has increased significantly:

Ind AS 107 defines credit risk as 'the risk that one party to a financial instrument will
cause a financial loss for the other party by failing to discharge an obligation’.
♦ When determining whether the recognition of lifetime expected credit losses is
required, an entity shall consider reasonable and supportable information that is
available without undue cost or effort and that may affect the credit risk on a financial
instrument.
♦ The following non-exhaustive list of information may be relevant in assessing changes
in credit risk:
(a) significant changes in internal price indicators of credit risk as a result of a
change in credit risk since inception, including, but not limited to, the credit
spread that would result if a particular financial instrument or similar financial
instrument with the same terms and the same counterparty were newly originated
or issued at the reporting date.

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(b) other changes in the rates or terms of an existing financial instrument that would
be significantly different if the instrument was newly originated or issued at the
reporting date (such as more stringent covenants, increased amounts of
collateral or guarantees, or higher income coverage) because of changes in the
credit risk of the financial instrument since initial recognition.
(c) significant changes in external market indicators of credit risk for a particular
financial instrument or similar financial instruments with the same expected life.
Changes in market indicators of credit risk include, but are not limited to:
i. the credit spread;
ii. the credit default swap prices for the borrower;
iii. the length of time or the extent to which the fair value of a financial asset
has been less than its amortised cost; and
iv. other market information related to the borrower, such as changes in the
price of a borrower's debt and equity instruments.
(d) an actual or expected significant change in the financial instrument's external
credit rating.
(e) an actual or expected internal credit rating downgrade for the borrower or
decrease in behavioural scoring used to assess credit risk internally.
(f) existing or forecast adverse changes in business, financial or economic
conditions that are expected to cause a significant change in the borrower's
ability to meet its debt obligations, such as an actual or expected increase in
interest rates or an actual or expected significant increase in unemployment rates
(g) an actual or expected significant change in the operating results of the borrower,
for eg.: actual or expected declining revenues or margins, increasing operating
risks, working capital deficiencies, decreasing asset quality, increased balance
sheet leverage, liquidity, management problems or changes in the scope of
business or organisational structure, etc. that results in a significant change in
the borrower's ability to meet its debt obligations
(h) significant increases in credit risk on other financial instruments of the same
borrower
(i) an actual or expected significant adverse change in the regulatory, economic, or
technological environment of the borrower
(j) significant changes in the value of the collateral supporting the obligation or in
the quality of third-party guarantees or credit enhancements;

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.81

(k) a significant change in the quality of the guarantee provided by a shareholder (or
an individual's parents) if the shareholder (or parents) have an incentive and
financial ability to prevent default by capital or cash infusion
(l) significant changes, such as reductions in financial support from a parent entity
or other affiliate or an actual or expected significant change in the quality of
credit enhancement, that are expected to reduce the borrower's economic
incentive to make scheduled contractual payments
(m) expected changes in the loan documentation including an expected breach of
contract that may lead to covenant waivers or amendments, interest payment
holidays, interest rate step-ups, requiring additional collateral or guarantees, or
other changes to the contractual framework of the instrument
(n) significant changes in the expected performance and behaviour of the borrower,
including changes in the payment status of borrowers in the group
(o) changes in the entity's credit management approach in relation to the financial
instrument; ie based on emerging indicators of changes in the credit risk of the
financial instrument, the entity's credit risk management practice is expected to
become more active or to be focused on managing the instrument, including the
instrument becoming more closely monitored or controlled, or the entity
specifically intervening with the borrower.
(p) Other past due information.
• 30 days past due rebuttable presumption:
Regardless of the way in which an entity assesses significant increases in credit risk, there
is a rebuttable presumption that the credit risk on a financial asset has increased
significantly since initial recognition when contractual payments are more than 30 days past
due.
- An entity can rebut this presumption if the entity has reasonable and supportable
information that is available without undue cost or effort, that demonstrates that the
credit risk has not increased significantly since initial recognition even though the
contractual payments are more than 30 days past due.
- When an entity determines that there have been significant increases in credit risk
before contractual payments are more than 30 days past due, the rebuttable
presumption does not apply.
• What is credit impaired financial assets:
♦ A financial asset is credit-impaired when one or more events that have a detrimental
impact on the estimated future cash flows of that financial asset have occurred.

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 12.82 FINANCIAL REPORTING

Evidence that a financial asset is credit-impaired include observable data about the
following events:
(a) Significant financial difficulty of the issuer or the borrower;
(b) Breach of contract, such as a default or past due event;
(c) Lender(s) of the borrower, for economic or contractual reasons relating to the
borrower’s financial difficulty, having granted to the borrower a concession(s)
that the lender(s) would not otherwise consider;
(d) It is becoming probable that the borrower will enter bankruptcy or other financial
reorganisation;
(e) the disappearance of an active market for that financial asset because of
financial difficulties; or
(f) the purchase or origination of a financial asset at a deep discount that reflects
the incurred credit losses.
It may not be possible to identify a single discrete event-instead, the combined effect
of several events may have caused financial assets to become credit-impaired.
• Measurement of expected credit losses:
♦ An entity shall measure expected credit losses of a financial instrument in a way that
reflects:
(a) an unbiased and probability-weighted amount that is determined by evaluating a
range of possible outcomes;
(b) the time value of money; and
(c) reasonable and supportable information that is available without undue cost or
effort at the reporting date about past events, current conditions and forecasts of
future economic conditions.
♦ When measuring expected credit losses, an entity need not necessarily identify every
possible scenario. However, it shall consider the risk or probability that a credit loss
occurs by reflecting the possibility that a credit loss occurs and the possibility that no
credit loss occurs, even if the possibility of a credit loss occurring is very low.
♦ The maximum period to consider when measuring expected credit losses is the
maximum contractual period (including extension options) over which the entity is
exposed to credit risk and not a longer period, even if that longer period is consistent
with business practice.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.83

♦ An entity may use practical expedients when measuring expected credit losses.
- An example of a practical expedient is the calculation of the expected credit
losses on trade receivables using a provision matrix. The entity would use its
historical credit loss experience for trade receivables to estimate the 12-month
expected credit losses or the lifetime expected credit losses on the financial
assets as relevant. A provision matrix might, for example, specify fixed provision
rates depending on the number of days that a trade receivable is past due (for
example, 1 per cent if not past due, 2 per cent if less than 30 days past due, 3
per cent if more than 30 days but less than 90 days past due, 20 per cent if 90–
180 days past due etc).
- Depending on the diversity of its customer base, the entity would use appropriate
groupings if its historical credit loss experience shows significantly different loss
patterns for different customer segments. Examples of criteria that might be used
to group assets include geographical region, product type, customer rating,
collateral or trade credit insurance and type of customer (such as wholesale or
retail).
Illustration 42 :12 month expected credit loss – Probability of default approach
Entity A originates a single 10 year amortising loan for CU1 million. Taking into
consideration the expectations for instruments with similar credit risk (using reasonable and
supportable information that is available without undue cost or effort), the credit risk of the
borrower, and the economic outlook for the next 12 months, Entity A estimates that the loan
at initial recognition has a probability of default (PoD) of 0.5 per cent over the next 12
months. Entity A also determines that changes in the 12-month PoD are a reasonable
approximation of the changes in the lifetime PoD for determining whether there has been a
significant increase in credit risk since initial recognition. Loss given default (LGD) is
estimated as 25% of the balance outstanding. Calculate loss allowance.
Solution
At reporting date, no change in 12-month POD and entity assesses that there is no
significant increase in credit risk since initial recognition – therefore lifetime ECL is not
required to be recognised.
Particulars Details
Loan ` 1,000,000 (A)
LGD 25% (B)
PoD – 12 months 0.5% (C)
Loss allowance (for 12-months ECL) ` 1,250 (A*B*C)
*****

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 12.84 FINANCIAL REPORTING

Illustration 43: 12 month expected credit loss – Loss rate approach

Bank A originates 2,000 bullet loans with a total gross carrying amount of CU 500,000. Bank
A segments its portfolio into borrower groups (Groups X and Y) on the basis of shared credit
risk characteristics at initial recognition. Group X comprises 1,000 loans with a gross
carrying amount per client of CU 200, for a total gross carrying amount of CU 200,000.
Group Y comprises 1,000 loans with a gross carrying amount per client of CU 300, for a total
gross carrying amount of CU 300,000. There are no transaction costs and the loan contracts
include no options (for example, prepayment or call options), premiums or discounts, points
paid, or other fees. Calculate loss rate when
Group Historic per annum average defaults Present value of observed loss assumed
X 4 CU 600
Y 2 CU 450

Solution
- Bank A measures expected credit losses on the basis of a loss rate approach for
Groups X and Y. In order to develop its loss rates, Bank A considers samples of its
own historical default and loss experience for those types of loans.
- In addition, Bank A considers forward-looking information, and updates its historical
information for current economic conditions as well as reasonable and supportable
forecasts of future economic conditions. Historically, for a population of 1,000 loans in
each group, Group X's loss rates are 0.3 per cent, based on four defaults, and
historical loss rates for Group Y are 0.15 per cent, based on two defaults.
Number Estimated Total Historic Estimated Present Loss rate
of clients per client estimated per annum total value of
in sample gross gross average gross observed
carrying carrying defaults carrying loss
amount at amount at amount at assumed
default default default
Group A B C=A×B D E=B×D F G=F÷C
X 1,000 CU 200 CU 2,00,000 4 CU 800 CU 600 0.3%
Y 1,000 CU 300 CU 3,00,000 2 CU 600 CU 450 0.15%

*****
Illustration 44: Life time expected credit losses (provision matrix for short term
receivables)
Company M, a manufacturer, has a portfolio of trade receivables of CU 30 million in 20X1
and operates only in one geographical region. The customer base consists of a large
number of small clients and the trade receivables are categorised by common risk
characteristics that are representative of the customers' abilities to pay all amounts due in
accordance with the contractual terms. The trade receivables do not have a significant

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.85

financing component in accordance with Ind AS 115. In accordance with paragraph 5.5.15
of Ind AS 109 the loss allowance for such trade receivables is always measured at an
amount equal to lifetime expected credit losses.
Please use the following information of debtors outstanding:
Gross carrying amount
Current CU 15,000,000
1–30 days past due CU 7,500,000
31–60 days past due CU 4,000,000
61–90 days past due CU 2,500,000
More than 90 days past due CU 1,000,000
CU 30,000,000
Company M uses following default rates for making provisions:
Current 1–30 days 31–60 61–90 days More than 90
past due days past due days past due
past due
Default rate 0.3% 1.6% 3.6% 6.6% 10.6%
Determine the expected credit losses for the portfolio
Solution
To determine the expected credit losses for the portfolio, Company M uses a provision
matrix. The provision matrix is based on its historical observed default rates over the
expected life of the trade receivables and is adjusted for forward-looking estimates. At
every reporting date the historical observed default rates are updated and changes in the
forward-looking estimates are analysed. In this case it is forecast that economic conditions
will deteriorate over the next year.
On that basis, Company M estimates the following provision matrix:
Current 1–30 31–60 days 61–90 days More than 90
days past due past due days
past due past due
Default 0.3% 1.6% 3.6% 6.6% 10.6%
rate
The trade receivables from the large number of small customers amount to CU 30 million
and are measured using the provision matrix.
Gross carrying Lifetime expected credit loss
amount allowance (Gross carrying amount x
lifetime expected credit loss rate)
Current CU 15,000,000 CU 45,000
1–30 days past due CU 7,500,000 CU 120,000

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 12.86 FINANCIAL REPORTING

31–60 days past due CU 4,000,000 CU 144,000

61–90 days past due CU 2,500,000 CU 165,000
More than 90 days past due CU 1,000,000 CU 106,000
CU 30,000,000 CU 580,000

*****

QUICK RECAP
• The classification and measurement of financial instruments are summarized as below :
Financial Assets Financial Liabilities Equity
Classification Amortised FVTOCI FVTPL Amortised FVTPL -
Cost Cost
Basis of  BM test to  BM test to  Held for  Default  If held for -
Classification collect collect & trading criterial trading
 SPPI test sell (SPPI or  Entity
 SPPI test BM test elects
fail) FVTPL
(using fair
value
option)
Initial  Fair Value  Fair Value  Fair  Fair Value  Fair Value  Fair
recognition Value Value
Subsequent  Amortised  Fair Value  Fair  Amortised  Fair Value  No Re-
recognition Cost Value cost measur
ement

• Financial asset (FA) will be classified as amortised cost if the objective is to hold the
financial asset in order to collect contractual cash flows and contractual terms give rise to
cash flows that are Solely Payments of Principal and Interest (SPPI) on the principal amount
outstanding.
• Contractual terms give rise to cash flows that are Solely Payments of Principal and Interest
on the principal amount outstanding. Contractual cash flows must be consistent with a basic
lending arrangement. In respect of Interest element, factors such as time value of money,
Credit risk, Liquidity, profit margin, service or administrative costs etc. should be
considered. Contractual cash flows linked to features such as changes in equity or
commodity prices, would not pass the SPPI test because they introduce exposure to risks or
volatility. SPPI Test will be met if there is a prepayment penalty i.e. additional compensation
for early termination or extension of contract.

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 ACCOUNTING AND REPORTING OF FINANCIAL INSTRUMENTS 12.87

• An entity may have one of the following models for its debt instruments :
(a) Hold to collect contractual cash flows
(b) Hold to collect contractual cash flows and selling financial assets
(c) Other business model – Actively buying & Selling
• Financial asset (FA) in debt instruments is measured at fair value through OCI (FVTOCI) if it
meets both ‘Hold-to-collect and sell’ business model test and ‘SPPI’ contractual cash flow
characteristics test.
• In respect of Financial asset (FA) in equity instruments, Ind AS 109 requires all equity
investments to be measured at fair value.All changes in fair value to be recognised in profit
or loss. However, Entities can make an irrevocable election at initial recognition to classify
the instruments as at FVOCI. Such option is available instrument by instrument i.e. (item by
item) and all subsequent changes in fair value being recognised in OCI. Dividends received
on equity investments to be recognised in profit or loss.
• Transaction costs are incremental costs that are directly attributable to the acquisition, issue
or disposal of a financial instrument

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