Ind AS & Derivative Accounting!
By: Ashish Gupta, Partner, Walker Chandiok & Co LLP & Keyur Dave, Director, Grant Thornton India LLP
Derivative is an instrument which derives its value from an underlying. Derivative is technically not a new concept, since under Indian GAAP, guidance is provided on its application though we agree that it is not absolutely in line with global accounting standards. It is critical to assess whether any instruments fulfils the definition of derivative or not? There are three basic aspect of derivative definition. 1) it is settled at a future date 2) requires no initial investment or little initial investment and 3) its value changes in response to change in underlying provided in case of non-financial variable that the variable is not specific to a party to the contract. Say for example, entity A entered into a contract as on September 30, 2014 to buy 100 USD on December 1, 2014 at the rate of 61. One has to analyse whether this contract meets the definition? Yes it is, since settled at future date, no initial payment and based on INR-USD exchange rate as underlying. Derivative instrument can have underlying which can be specified interest rate, commodity price, foreign exchange rate, credit index or any other variable.
Currently, under Indian notified accounting standard guidance, no standards directly deal with accounting for derivative except for Accounting Standard (AS) 11 “The effects of changes in foreign exchange rates”, which mandates to account for a forward contract or an instrument similar in nature for any of the existing (recognised) assets and liabilities. Forward contracts, intended for trading or speculation purpose, are also governed by AS 11. Further, a guidance issued by the Institute of Chartered Accountants of India (ICAI) in 2008, requires that contracts that do not meet the definition of a forward contract under AS 11, be mark to market and accounted for using the principles of prudence, whereby, any losses arising from such mark to market be recognised in the profit and loss account and gains, if any, be ignored. The aforementioned guidance also encouraged companies to adopt AS 30i “Financial Instruments: Recognition and Measurement” to the extent it is not contradictory to any notified AS. If one does not adopt AS 30, there is no guidance on accounting for embedded derivatives.
Accordingly, under the current standards, there are multiple guidance a company may choose from (AS 11 approach, AS 30 approach, ICAI prudence note), leading to different applications and hence defeating the very basis for which consistent standards were enunciated. Say for example, if company A has futures and accounted based on ICAI guidance, thus only losses are recognised while any gains are ignored. While company B has futures, but adopted AS 30, to the extent not contradictory to other notified standards, and accounted even gains to the profit and loss account.
Once the Ind AS framework will be applicable, then derivative accounting shall be same for all instruments. There will not be any difference between forward and rest of the derivatives. There is no concept of “prudence” approach and all derivatives are marked to market and gains or losses recorded in the profit and loss account except when an entity applies hedge accounting.
Presently Indian GAAP does not discuss about “embedded derivative” and thus companies do not assess for it at all. Embedded derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract with the effect that some of the cash flows of the combined instruments vary in a way similar to a stand-alone derivative. There is a clear guidance under Ind AS on how to assess embedded derivatives and their accounting (segregation from the host contract). Embedded derivative may certainly play a devil’s role. Given that current GAAP neither requires any assessing nor provides any accounting disclosure for embedded derivatives, it’s quite critical to assess its impact before real transition to Ind AS to understand how it will impact entity’s Revenue, EBITA or Profit.
Few cases of embedded derivatives:-
|Hybrid contract||Host Contract||Embedded derivative|
|Entity issued a Bond which is convertible into equity shares||Bond liability||Conversion option|
|Lease contract where lease charges are linked with retail price index||Lease contract||Retail price index|
|Entity issued a 5 year notes and interest is based on changes in the share price of entity.||Note liability||Share price linked interest rate|
Embedded derivative would not be recorded as usual business elements. This will influence the business strength since it will be accounted separately in the profit and loss account, if not closely related, and may create wider impact to business numbers , inter-alia, EBITA, EPS and thus it may require more robust investor communication. It is not wrong to say that investors would see change in accounting, while the underlying business remains the same and may be wary of volatility such accounting brings to the profits of a company.
Example one: Entity X invests in bond issued by entity Y at INR 10 million. The term of the bond is 5 years and pays fixed interest annually at 5% a year. The term of the contract allows entity X an option to convert the bond into equity shares. In the books of X – bonds will be accounted as a financial asset with a purchase option of conversion as an embedded derivative.
Example two: Entity X issues bonds to entity Y at INR 10 million. The term of the bond is 5 years and pays interest which is linked to equity index. In the books of X – bonds will be accounted as liability where interest payment linked with equity index as an embedded derivative.
With the move to Ind-AS, world of accounting is going to accept established platform, however it may come with an additional cost and time. Review factor needs to be taken into consideration as well. It is better to initiate the process of assessing derivative and embedded derivative early to avoid any last minute rush which may be costly for an entity and its investors.
The article appeared in ‘The Firm’ on CNBC TV18 .The article can be found here.