A financial instrument is a contract that gives rise to a financial asset in one entity with a corresponding liability or equity in another entity. Most monetary items will get covered by this definition such as trade receivables/payables, investments in shares/debentures, retention money, trade deposits, derivatives, financial guarantees, and loans and advances. Some examples of items which are not financial instruments are tax liability, advance received for goods or services, provision for disputes and prepaid expenses since these do not have a contractual right to receive or pay cash.

All financial assets would need to be classified into four categories, comprising (i) fair value through profit or loss (FVPL), (ii) held-to-maturity (HTM), (iii) loans and receivables (L&R) and (iv) available-for-sale (AFS). All financial assets will have to be recorded at respective fair values at the time of initial recognition. IAS-39 requires FVPL and AFS assets to be measured at fair values at each subsequent reporting period. In case of FVPL assets, the unrealized gain/loss is recognized in the profit and loss account whereas for AFS investments, it is recognized in equity until actually realized, whereupon it is transferred to the income statement. HTM and L&R assets are reflected at amortized cost.

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IAS-39 also deals with derivative instruments in a comprehensive manner. A few examples of derivatives are share options, currency forwards, commodity futures, interest rate swaps, equity swaps, credit swaps and purchased or written currency options. Apart from stand-alone derivatives, IAS-39 requires derivatives embedded or contained in other contracts to be separated and accounted separately. To cite an example, a convertible bond held by an entity has embedded derivative in the form of the equity convertible option. Similarly, if two Indian entities have a contract for supply of goods/services denominated in euros, then there is an embedded rupee-euro forward currency derivative, which will need to be separated from the host financial asset and valued separately.

IFRS requires all derivatives to be fairly valued at each reporting date and gain or loss is to be recognized in the income statement, unless it satisfies the effective hedging rules, in which case such gains/losses are recognized in equity. The hedge accounting rules under IFRS are quite stringent. It requires extensive documentation and the hedge effectiveness test needs to be applied, which means that change in fair value of the hedged item and change in fair value of the hedge should show a correlation of 80-125%. If the changes don’t fall within this band, then the hedge is ineffective and, therefore, fair value gains/losses on the hedging contract will have to be taken to the income statement.

IFRS will have significant impact on the debt-equity ratio of entities that have issued quasi equity instruments such as preference shares and convertible bonds. Presently, redeemable preference shares are classified under equity as per Schedule VI of the Companies Act. However, under IAS-32, they will get classified as liability, since they meet the characteristic of a liability, i.e., redemption after a fixed period and dividend at a fixed rate. In fact, under IFRS, the dividend will be treated as interest cost and not be shown as an appropriation item in the profit and loss account. If such fixed dividend/interest rate is lower than the market rate, then the value of the preference debt will also change so as to reflect its underlying fair value. In case of convertible instruments such as foreign currency convertible bonds (FCCB), firms will have to fair value the bond liability resulting in interest charge for income statement, even if FCCB is at zero coupon rates. FCCB will be subjected to split accounting, which requires separation of the debt component and the option derivative at respective fair values.

In the case of banks, the existing provisions on non-performing assets are based on guidelines laid down by the Reserve Bank of India, as per the ageing pattern. Under IFRS, they will have to be tested for impairment. Provisioning for standard assets will not be permitted under IFRS. For secured loans, no provision may be required under IFRS though RBI guidelines may require provisioning. The application of IAS-39 would also change accounting for items such as financial guarantees. In such cases, the carrying value of the loans would have to be impaired or written down at inception so as to reflect proper annualized market interest returns. Moreover, the fair values will also have to factor credit risk relating to the loan product portfolio as well as the intended borrower segment. Therefore, the earnings and financial position of most entities is going to be significantly impacted on the advent of IAS-39. It will affect key ratios and performance indicators for most banks and financial institutions, including capital adequacy ratios.

India will move to IFRS starting 2011. Navin Agrawal is a director with Ernst & Young India Pvt. Ltd. This is the eighth in a series that analyses the impact of IFRS on industries and regulatory issues pertaining to its convergence with Indian GAAP. Respond to this column at feedback@livemint.com