Liabilities that arise from a contractual arrangement to deliver cash or another financial asset to another entity are classified as financial instrument. IFRS (IAS-39) requires that those liabilities should initially be measured at fair value. Initial fair value is normally the transaction price. IAS-39 assumes that the transaction price is the best evidence of fair value. However this will not always be the case. For example, the initial fair value of an interest-free or low interest loan is lower than the amount of the loan obtained by the entity. For example, if an entity has borrowed Rs 1,000 as interest-free loan from the government, repayable after ten years, the fair value of the liability is the present value of the amount received. PV is calculated by discounting that amount using the market rate of interest. If we assume that the entity could borrow the money from the market at an interest rate of ten percent per annum, the fair value of the loan is Rs. 386. The loan should initially be measured atRs 386 and the difference of Rs. 614 should be accounted for as government grant.
Liabilities, which are financial instruments, are subsequently measured at amortised cost using the effective interest method. In our example above, the effective interest rate is ten per cent. Therefore, using the effective interest rate of ten percent, Rs 614 will be amortised over the tenure of the loan. For example, at the end of the first year, interest will be recognised in the profit and loss account at Rs 38.6 (386 × 0.10) and the liability (loan) will be measured at Rs 424.6 (386 + 38.6). At the end of the second year, interest will be recognised at Rs 42.5 (424.6 × 0.10) and the loan will be measured at Rs 467.10 (424.6 + 42.5). The same method will be followed at each subsequent year. This will result in recording the loan at the end of the tenth year at Rs 1,000. Therefore, no gain or loss will arise on repayment of the loan unless it is settled for a lower amount.
Indian GAAP is to initially measure liabilities at the transaction price. Subsequently, liabilities are measured at the amount outstanding at the balance sheet date. Therefore, under the Indian GAAP, the loan in the example above should initially and subsequently be measured at Rs 1000; and no interest will be charged in the profit and loss account for any of the accounting periods covered by the tenure of the loan. The government grant, in the form of interest subsidy, will not be disclosed. Therefore, accounting principle stipulated in IFRS is superior to the Indian GAAP.
Misplaced concern
Initial measurement of a loan at fair value may have a significant impact on the capital gearing ratio, which is used to measure the ability of the entity to honour long term financial commitments. A question arises whether measurement of a zero-interest or low-interest loan at PV unduly lowers the gearing ratio and allows an entity to borrow beyond its capacity to repay debt and thus, enhances the credit risks of investors already provided debt capital to the entity. This concern is not founded on sound financial logic. Assume that an entity borrows Rs 1,000 at the market rate of interest. Under the Indian GAAP, the same should be recognised at the transaction price of Rs 1,000, which is the present value of the total cash outflow (total of the principal amount to be repaid at the end of the loan term and interest payable periodically). In a way, the Indian GAAP applies the accounting principle stipulated in IFRS to measure a loan obtained at the market rate of interest. However, it does not apply the same accounting principle in measuring loan obtained at a zero or concessional interest rate. Thus, it is the Indian GAAP and not the fair value measurement principle that obscures the fair presentation of debt and interest expense, and distorts the gearing ratio and the interest coverage ratio.
Conclusion
Fair value measurement principle may be criticised on account of subjectivity in measurement because active markets do not exist for most liabilities. But, analysts value relevance more than they value reliability.
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