Making financial innovations work

ACCOUNTANCY

The Institute of Chartered Accountants of India has just issued two new accounting standards on accounting for financial instruments: 'AS-30, Financial Instruments: Recognition and Measurement' and 'AS-31, Financial Instruments: Presentation'. All business enterprises are recommended to adopt the new standards from April 1, 2009 and it will be mandatory to adopt these standards from 2011. The standards are based on the International Financial Reporting Standards (IFRS).

A financial instrument is a bundle of financial rights and obligations arising from a contract between two or more parties. The Indian GAAP often presents a financial instrument based on the more important component of those rights and liabilities. For example, a convertible debenture is presented as a liability, while it has two components: a liability and an option to convert the loan into equity. Appropriate accounting for financial instruments requires unbundling of rights and obligations and to account for each component separately. Therefore application of accounting principles and methods for accounting for financial instruments requires understanding of the essentials of finance theory. AS-30 adopts the approach of unbundling assets and liabilities inherent in a financial instrument.

A financial instrument gives rise to a financial asset of one party and a financial liability or equity for the other party. A chain of contractual rights or contractual obligations is a financial instrument if it will ultimately lead to receipt or payment of cash or to the acquisition or issue of an equity instrument. Therefore, a contractual right or a contractual obligation to receive, deliver, or exchange financial instruments is itself a financial instrument.

Financial instruments come in various shapes and flavours. They range from a simple contract between two parties to receive or pay an amount (e.g. trade amounts receivable and payable) to exotic options. For long, it was considered that rights and obligations arising from complex financial contracts cannot be measured reliably. Therefore, many of those rights and obligations were off-balance sheet items. Only recently have makers of accounting standards decided to formulate standards that will reduce the number of off-balance sheet items. However, due to the complexity of rights and obligations arising from complex financial instruments and the complexity of transactions concerning financial instruments, many accounting issues are yet to be resolved satisfactorily.

The issuer of a financial instrument is required to classify it as a liability or as equity based on the terms and conditions of the contract. In case of a compound instrument (e.g. convertible debenture), components should be presented in financial statements as equity or liability based on the terms and conditions of the contract.

An equity instrument is any contract that evidences a residual interest in the assets of any equity after deducting all of its liabilities. As a general principle, a contract that will be settled by an entity receiving or delivering a fixed number of its own shares for no future consideration is an equity instrument. For example, when an enterprise issues shares in consideration of cash or some other asset or service, the transaction does not result in outflow of future consideration from the enterprise. So long as the instrument involves an unconditional obligation to deliver cash or another financial asset, it should be classified and accounted for as a liability. A redeemable preference share should be classified as liability and not as equity because it gives rise to an unconditional obligation to deliver cash.

The general principle is that a financial instrument that gives the holder a right to put back the same to the issuer for cash or another financial asset is a financial liability. Therefore, a mutual fund should present outstanding units of an open ended mutual fund as a liability and not as equity.

A contract that will be settled by an entity receiving or delivering a variable number of its own shares whose value equals a fixed amount is a financial liability. For example, consider a company which sold goods to another company for Rs 10 million on credit. The payment will fall due on a subsequent date. As per the purchase agreement, the buyer will issue an adequate number of its own equity shares, based on the market value of its shares at the date of settlement, to settle the obligation. The buyer should recognise the payment due to the seller as a liability, although the obligation will be settled by issue of equity shares. On issue of equity shares, the liability will get extinguished and equity in the books will increase by the corresponding amount.

Thus, AS-31 will improve the presentation of financial instruments significantly.

AS-30 provides for classification of assets in four categories: financial asset or financial liability at fair value through profit or loss; held-to maturity investments; loans and receivables; and available-for-sale financial assets. It has adopted fair value as the basis for measurement of financial assets.

Except in certain situations, a company has the option to designate a financial asset as 'a financial asset at fair value through profit or loss'. A financial asset held for trading should necessarily be classified as 'asset at fair value through profit or loss'. The difference in the fair value of financial assets designated as 'an asset at fair value through profit or loss' at the beginning of the period and that at the end of the period should be recognised as profit or loss in the profit and loss account.

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity. A held to maturity investment is carried in the balance sheet at the amortised cost. Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. Loans and receivables are carried at the amortised cost unless the company intends to sell the same immediately. Demonstration of 'ability and intend to hold the investment to maturity' is not a prerequisite for carrying loans and receivables at cost. An example of loans and receivables is the loan advance by a financial institution to one of its constituent.

'Available for sale' is the residual category. An investment which is classified as 'available for sale' is carried in the balance sheet at fair value. Any change in fair value during the period is directly recognised in equity and the accumulated change is recognised in the profit and loss account only when the investment is sold.

As-30 provides detailed guidelines for accounting for securitisation, recognition and de-recognition of financial assets and liabilities and hedge accounting.

Application of new standards will require modification of existing regulations issued by SEBI and RBI. It will also require a change in the mindset. We have over-emphasised the principle of conservatism in the past. For example, RBI requires banks and financial institutions to ignore increase in the fair value of investments measured at fair value, but to provide for reduction in fair value. Similarly, at present, non-financial companies carry current investments at cost or market value whichever is lower and long term investments at cost. They provide for permanent diminution in value of long term investments. Measurement of financial instruments at fair value brings transparency in financial reporting.

Financial innovation will continue making the asset/liability structure of instruments more complex and their analysis more challenging. The accounting profession must take this as a challenge and make sure that the training of accountants keeps pace with the developments in financial markets.