A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Financial asset is cash, equity shares issued by another entity, and a contractual right to receive cash or another financial asset. A derivative instrument is recognised either as an asset or a liability depending on whether the price of the instrument is favourable or unfavourable to the entity. Today we shall not discuss accounting for derivatives.
Pre-paid expense (e.g. advance paid to a vendor against an order for supply of goods or services) is not a financial asset. It represents a right to receive goods or services against the amount paid to the counter party.
Measurement
Under IFRS, financial assets are initially recognised at fair value (FV). Subsequently, loans and advances and investments that the entity intends to hold till maturity are measured at amortised cost using the effective interest method, and all other financial assets are measured at FV.
Receivables
On adoption of IFRS, the Indian accounting practice for measuring revenue and receivables will change. If an entity extends credit to its customers for a long period, usually for more than six months, the FV of the consideration will be lower than the nominal amount. Therefore, the receivable and revenue is recognised at FV and not at the amount mentioned in the invoice preferred on the customer. FV is the present value (PV) of the amount receivable from the customer discounted at the interest rate at which the customer could borrow from the market at the same terms and conditions. Let us take an example. On January 1, 2010, an entity sold goods to a customer for Rs 1,000. The amount is expected to be collected on December 31, 2011. No interest is charged from the customer. The market rate of interest is 15 per cent. The credit period is longer than six months. Therefore, the sale and correspondingly the receivable are recognised at the FV of the consideration, which is the PV of the cash flow. Therefore the sale will be recognised Rs 870. In the year 2009-10 interest income will be recognised at Rs 32 (Rs 870*.15)/4). In the year 2010-11, interest income will be recognised at Rs 98. Recognition of interest income will increase the amount due from the customer. Thus on March 31, 2011, the amount due from the customer will stand at Rs. 902, and on December 31, 2011, the amount due from the customer will stand at Rs 1,000.
FV is not an entity-specific current value. It is estimated based on the market perception. Therefore, in estimating the FV, the credit period allowed to a customer is not relevant. The past pattern of collection from customers in the same class is relevant because that creates the market perception on when the cash will be collected.
Loan
The FV of loan granted to an employee, vendor or any other entity at an interest rate favourable than the rate at which the counterparty could borrow from the market with similar terms and conditions, will be lower than the nominal amount. The difference between the nominal amount and the FV should be recognised in the profit and loss account as an expense. For example, if the loan amount is Rs 1,000 and the FV is Rs 800, Rs 200 should be recognised as an expense for the period in which the loan is granted. In case of loan to employees the expense should be a part of employee compensation. In other cases, the expense represents the cost of getting some intangible benefits from the counter party and therefore it should be disclosed as an appropriate line item. The difference (Rs 200 in the example) should also be amortised over the loan term as a part of interest income using the effective interest rate, which is the market interest rate. In estimating the FV of loan, expected loan pre-payments should be taken into consideration.
Conclusion
Accounting principles is not complex and are superior to the current Indian accounting practice. Theref-ore, we may expect that those will be incorporated in accounting standards, which will be applied by unlisted companies with net worth of Rs 500 crore or less.
Email id: asish.bhattacharyya@gmail.com
