Ind AS 109 - Financial Instruments

The ECL model requires recognizing impairment based on expected losses, rather than incurred losses. It uses a three-stage approach: Stage 1 (12-month ECL for performing assets), Stage 2 (Lifetime ECL for assets with significant increase in credit risk), and Stage 3 (Lifetime ECL for credit-impaired assets).

Hedge accounting under Ind AS 109 is optional but allows entities to reflect the risk management activities in their financial statements by matching the timing of recognition of gains and losses on the hedging instrument and the hedged item. To apply hedge accounting, stringent criteria must be met:

1. Eligibility: The hedging instrument and hedged item must be eligible for hedge accounting.
2. Documentation: At the inception of the hedge, there must be formal designation and documentation of the hedging relationship, the entity's risk management objective and strategy for undertaking the hedge, and how the hedging instrument's effectiveness will be assessed.
3. Effectiveness Assessment: The hedge must be expected to be highly effective in offsetting changes in fair value or cash flows attributable to the hedged risk. Ind AS 109 requires an economic relationship between the hedged item and the hedging instrument, and that the effect of credit risk does not dominate the value changes that result from that economic relationship. The hedge ratio must be the same as that actually used in the risk management strategy.
4. Prospective Effectiveness: The hedge must be assessed on an ongoing basis and determined to have been effective throughout the financial reporting periods for which it was designated.

Consequences of Failing Effectiveness Requirements:
If a hedge relationship fails to meet the effectiveness requirements, or if the risk management objective changes, hedge accounting must be discontinued prospectively. This means:

• Prospective Discontinuation: No retrospective adjustments are made. The hedge accounting stops from the date the criteria are no longer met.
• Hedging Instrument: The hedging instrument (e.g., derivative) will be measured at FVTPL, with all subsequent changes in fair value recognised immediately in profit or loss.
• Hedged Item (Fair Value Hedge): For a fair value hedge, the cumulative adjustment to the carrying amount of the hedged item arising from the hedged risk is amortised to profit or loss over the remaining life of the hedged item, or immediately if the hedged item is derecognised.
• Hedged Item (Cash Flow Hedge): For a cash flow hedge, the cumulative gain or loss on the hedging instrument that has been recognised in OCI remains in OCI until the forecast transaction occurs or is no longer expected to occur. If the forecast transaction is no longer expected to occur, the amount accumulated in OCI is immediately reclassified to profit or loss.

Hedge accounting allows an entity to reflect its risk management activities in its financial statements by matching the gains and losses on hedging instruments with those on hedged items. Ind AS 109 provides three types of hedging relationships: fair value hedge, cash flow hedge, and hedge of a net investment in a foreign operation.

Ind AS 109 provides a principles-based approach to derecognition of financial assets. An entity derecognises a financial asset when, and only when:

1. The contractual rights to the cash flows from the financial asset expire. This is the simplest case, for example, when a loan is fully repaid.

2. It transfers the financial asset and the transfer qualifies for derecognition. This requires a detailed assessment of the extent to which the entity retains or transfers the risks and rewards of ownership of the financial asset. The transfer criteria are applied in a two-step approach:

   • Step 1: Has the entity transferred its contractual rights to receive cash flows from the financial asset, or has it retained the contractual rights but assumed an obligation to pay the cash flows to one or more recipients? If neither of these conditions is met, the asset is not derecognised.
   • Step 2: If Step 1 is met, the entity must evaluate the extent to which it retains the risks and rewards of ownership of the financial asset.
     • Substantially all risks and rewards transferred: The entity derecognises the financial asset. For example, an outright sale of receivables without recourse.
     • Substantially all risks and rewards retained: The entity continues to recognise the financial asset. This is often the case in factoring arrangements with full recourse, where the entity retains the credit risk.
     • Neither substantially all risks and rewards transferred nor retained (i.e., control assessment): The entity then assesses whether it has retained control of the financial asset. If control is retained, the entity continues to recognise the asset to the extent of its continuing involvement. If control is not retained, the entity derecognises the asset.

Practical application in Securitisation/Factoring:

• Securitisation: In a securitisation, a pool of assets (e.g., mortgages, receivables) is transferred to a Special Purpose Entity (SPE). Derecognition depends on whether the originator has transferred substantially all the risks and rewards of ownership to the SPE. If the originator provides guarantees or retains subordinated interests, it might retain significant risks, preventing full derecognition.
• Factoring: In factoring, receivables are sold to a factor. If the factoring is 'without recourse', the entity typically transfers substantially all risks and rewards (credit risk) and derecognises the asset. If it's 'with recourse', the entity usually retains significant credit risk, meaning derecognition might not occur, or only partial derecognition to the extent of the continuing involvement.

Hedge accounting under Ind AS 109 aims to align the accounting for hedging instruments with an entity's risk management activities, thereby reducing volatility in profit or loss. To apply hedge accounting, an entity must meet three key conditions at the inception of the hedging relationship and on an ongoing basis:

1. Eligibility: The hedging relationship must consist only of eligible hedging instruments and eligible hedged items.
2. Documentation: There must be formal designation and documentation of the hedging relationship, the entity’s risk management objective and strategy for undertaking the hedge, and the method of assessing hedge effectiveness.
3. Effectiveness: The hedging relationship must meet all of the following hedge effectiveness requirements:
   • There is an economic relationship between the hedged item and the hedging instrument.
   • The effect of credit risk does not dominate the value changes that result from that economic relationship.
   • The hedge ratio of the hedging relationship is the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.

Differentiation between Fair Value Hedge and Cash Flow Hedge:

• Fair Value Hedge: This hedges the exposure to changes in the fair value of a recognised asset or liability or an unrecognised firm commitment that is attributable to a particular risk and could affect profit or loss. For a fair value hedge, gains and losses on both the hedging instrument and the hedged item (attributable to the hedged risk) are recognised in profit or loss, offsetting each other.
• Cash Flow Hedge: This hedges the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability (e.g., future interest payments on variable-rate debt) or a highly probable forecast transaction, and could affect profit or loss. The effective portion of the gain or loss on the hedging instrument is recognised in Other Comprehensive Income (OCI) and reclassified to profit or loss when the hedged forecast transaction affects profit or loss. The ineffective portion is recognised immediately in profit or loss.

Ind AS 109 introduces a forward-looking Expected Credit Loss (ECL) model for impairment, replacing the incurred loss model. This model requires entities to recognise an allowance for expected credit losses at all times, not just when a loss event has occurred. The model operates in three stages:

1. Stage 1 (12-month ECL): For financial instruments that have not had a significant increase in credit risk since initial recognition, a loss allowance equal to the 12-month ECL is recognised. Interest revenue is calculated on the gross carrying amount of the asset.

2. Stage 2 (Lifetime ECL - Not Credit-Impaired): If the credit risk of a financial instrument has significantly increased since initial recognition but is not yet credit-impaired, a loss allowance equal to the lifetime ECL is recognised. Interest revenue is still calculated on the gross carrying amount of the asset.

3. Stage 3 (Lifetime ECL - Credit-Impaired): For financial instruments that are credit-impaired (i.e., objective evidence of impairment exists), a loss allowance equal to the lifetime ECL is recognised. Interest revenue is calculated on the net carrying amount (gross carrying amount less loss allowance).

Practical Implications for Indian Financial Institutions:

• Data Requirements: Requires robust data collection and analytical capabilities to assess changes in credit risk, historical loss experience, and forward-looking macroeconomic factors.
• Judgment: Significant judgment is involved in determining 'significant increase in credit risk', defining 'credit-impaired', and estimating probability of default, loss given default, and exposure at default.
• Procyclicality: The forward-looking nature can lead to higher provisions during economic downturns, potentially exacerbating economic cycles.
• Regulatory Alignment: Banks and NBFCs need to align their internal risk management frameworks and regulatory provisioning norms (e.g., RBI guidelines) with Ind AS 109 requirements, which can be complex due to differences in methodologies.
• Systems and Processes: Requires significant upgrades to IT systems and processes for credit risk management, financial reporting, and auditing.

The effective interest method is a method of calculating the amortized cost of a financial asset or liability and allocating the interest income or expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the gross carrying amount.

Ind AS 109 generally requires equity investments to be measured at Fair Value Through Profit or Loss (FVTPL). However, for certain equity investments that are not held for trading, an entity has an irrevocable option at initial recognition to present subsequent changes in their fair value in Other Comprehensive Income (OCI).

Key Aspects of the Irrevocable Election:

• Non-Trading Equity Investments: This option is available only for equity instruments that meet the definition of an equity instrument under Ind AS 32 and are not held for trading. 'Held for trading' implies frequent buying and selling to generate short-term profits.
• Initial Recognition: The election must be made at initial recognition of the equity instrument. Once made, it cannot be revoked.
• Fair Value Changes in OCI: All subsequent changes in the fair value of the investment are recognised in OCI. These amounts are accumulated in a separate component of equity.
• Dividend Income: Dividends from these investments are recognised in profit or loss when the entity's right to receive payment is established.

Implications for Subsequent Recycling to Profit or Loss:
One of the most significant implications of this election is that amounts recognised in OCI are never subsequently reclassified (recycled) to profit or loss. This applies to:

• Disposal/Sale: When the equity investment is sold, the cumulative gain or loss previously recognised in OCI is transferred directly within equity (e.g., from the 'FVOCI equity reserve' to 'retained earnings'). It is not recycled to profit or loss.
• Impairment: Unlike debt instruments measured at FVOCI, there is no impairment model for equity instruments measured at FVOCI. Any fair value declines are recognised directly in OCI and are not reclassified to profit or loss as impairment losses.

This election is typically made when the entity views the investment as a long-term strategic holding, and it wishes to avoid the volatility in profit or loss that would arise from fair value changes if the investment were classified as FVTPL.

Ind AS 109 classifies financial assets based on two criteria: the entity's business model for managing the financial assets and the contractual cash flow characteristics of the financial asset (SPPI test - Solely Payments of Principal and Interest).

1. Amortised Cost: A financial asset is measured at amortised cost if both of the following conditions are met: (a) The asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows, and (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (SPPI test).

2. Fair Value Through Other Comprehensive Income (FVOCI): A financial asset is measured at FVOCI if both of the following conditions are met: (a) The asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, and (b) The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding (SPPI test). For equity instruments, an irrevocable election can be made at initial recognition to present changes in fair value in OCI, provided they are not held for trading.

3. Fair Value Through Profit or Loss (FVTPL): A financial asset is measured at FVTPL unless it is measured at amortised cost or FVOCI. This is the default category. Additionally, an entity may irrevocably designate a financial asset as measured at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (an 'accounting mismatch') that would otherwise arise. All derivatives are measured at FVTPL unless designated as hedging instruments in an effective hedge relationship.

An embedded derivative is a component of a hybrid contract (a contract containing both a non-derivative host and an embedded derivative) that causes some of the cash flows of the combined contract to vary in a way similar to a stand-alone derivative. Ind AS 109 requires an embedded derivative to be separated from the host contract and accounted for as a stand-alone derivative at Fair Value Through Profit or Loss (FVTPL) if, and only if, all three of the following conditions are met:

1. The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract.
2. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative.
3. The hybrid contract is not measured at FVTPL (i.e., its changes in fair value are not already recognised in profit or loss).

If these conditions are met, the embedded derivative is separated and measured at FVTPL. The host contract is then accounted for under the appropriate Ind AS. If separation is not required or not possible (e.g., if the embedded derivative cannot be reliably measured), the entire hybrid contract must be measured at FVTPL.

Example: Consider a convertible bond. The bond itself is a debt instrument (the host contract), while the option allowing the holder to convert it into equity shares of the issuer is an embedded derivative. The economic characteristics of the conversion option (equity-like) are generally not closely related to the host debt contract. If the other conditions for separation are also met, the conversion option would be separated and accounted for as a derivative at FVTPL, and the host bond would be accounted for as a debt instrument (e.g., at amortised cost).

Ind AS 109 classifies financial assets based on the entity's business model for managing them: 1) Hold to collect contractual cash flows (Amortized Cost), 2) Hold to collect contractual cash flows and sell financial assets (FVTOCI), 3) Other business models, like trading (FVTPL).

A financial asset is classified at amortised cost if both conditions are met: 1) Business Model Test: The asset is held within a business model whose objective is to hold assets to collect contractual cash flows. 2) SPPI Test: The contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Ind AS 109 introduces a forward-looking Expected Credit Loss (ECL) model for the impairment of financial assets, replacing the previous incurred loss model. This model applies to financial assets measured at amortised cost or FVTOCI (debt instruments), as well as lease receivables and contract assets.

The three-stage impairment model is as follows:

1. Stage 1 (12-month ECL): Applies to financial instruments that have not experienced a significant increase in credit risk since initial recognition. The entity recognises a loss allowance based on the 12-month ECL, which represents the portion of lifetime ECLs resulting from default events possible within 12 months after the reporting date. Interest revenue is calculated on the gross carrying amount.
2. Stage 2 (Lifetime ECL - Not Credit-Impaired): Applies to financial instruments that have had a significant increase in credit risk since initial recognition but are not yet credit-impaired. The entity recognises a loss allowance based on the lifetime ECL, covering all possible default events over the expected life of the financial instrument. Interest revenue is still calculated on the gross carrying amount.
3. Stage 3 (Lifetime ECL - Credit-Impaired): Applies to financial instruments that are credit-impaired (i.e., objective evidence of impairment exists). The entity continues to recognise a loss allowance based on lifetime ECLs. However, interest revenue is calculated on the net carrying amount (gross carrying amount less loss allowance).

Practical Application for Trade Receivables: For trade receivables (and contract assets and lease receivables), Ind AS 109 permits a simplified approach. An entity is always required to measure the loss allowance at an amount equal to lifetime ECLs, irrespective of whether there has been a significant increase in credit risk. This simplified approach removes the need to track changes in credit risk for these specific assets, streamlining the impairment calculation.

Ind AS 109 mandates the classification of financial assets based on two primary criteria: the entity's business model for managing the financial assets and the contractual cash flow characteristics of the financial asset (often referred to as the 'Solely Payments of Principal and Interest' or SPPI test).

Business Model Test: This assesses how an entity manages its financial assets to generate cash flows. The models include:

1. Held to collect contractual cash flows: Assets are managed to realise cash flows by holding them to maturity.
2. Held to collect contractual cash flows and for selling financial assets: Assets are managed to realise cash flows through both collecting contractual cash flows and selling the assets.
3. Held for selling financial assets: This is the residual category, typically for assets held for trading or those that do not fit the other two models.

Contractual Cash Flow Characteristics (SPPI Test): This test determines whether the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Impact on Subsequent Measurement: The classification determines how the financial asset is subsequently measured:

• Amortised Cost (AC): Applied if the business model is 'held to collect' and the SPPI test is met. Subsequent measurement is at amortised cost using the effective interest method.
• Fair Value through Other Comprehensive Income (FVTOCI):
  • Debt Instruments: Applied if the business model is 'held to collect and sell' and the SPPI test is met. Subsequent measurement is at fair value, with gains/losses recognised in OCI (recyclable to P&L upon derecognition).
  • Equity Instruments: An irrevocable election can be made at initial recognition to present fair value changes in OCI (non-recyclable to P&L).
• Fair Value through Profit or Loss (FVTPL): This is the default category for all financial assets that do not meet the criteria for AC or FVTOCI, or if the fair value option is elected. Subsequent measurement is at fair value, with gains/losses recognised in P&L.

Ind AS 109 permits an entity to irrevocably designate a financial asset or financial liability as measured at fair value through profit or loss (FVTPL) at initial recognition. This is known as the 'Fair Value Option' (FVO).

Conditions for Financial Assets: An entity may designate a financial asset at FVTPL if doing so eliminates or significantly reduces an 'accounting mismatch' that would otherwise arise from measuring assets or liabilities or recognising gains and losses on them on different bases. This election is available even if the asset would otherwise be classified at amortised cost or FVTOCI based on the business model and SPPI tests.

Conditions for Financial Liabilities: An entity may designate a financial liability at FVTPL if:

1. It eliminates or significantly reduces an accounting mismatch.
2. A group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to key management personnel.

Implications of FVO:

• All gains and losses arising from changes in the fair value of the designated financial instrument are recognised in profit or loss.
• For financial liabilities designated at FVTPL, Ind AS 109 requires that the amount of change in the fair value of the financial liability attributable to changes in its own credit risk is presented in Other Comprehensive Income (OCI). This applies unless doing so would create or enlarge an accounting mismatch in profit or loss. The remaining fair value changes are presented in profit or loss. Amounts in OCI related to own credit risk are not recycled to profit or loss, even upon derecognition, but can be transferred within equity.
• The election to apply the FVO is irrevocable once made at initial recognition.