FINAL KICK COACHING INSTITUTE

Illustration 11
ABC Bank gave loans to a customer – Target Ltd. that carry fixed interest rate @ 10% per annum for a 5 year term and 12% per
annum for a 3 year term. Additionally, the bank charges processing fees @1% of the principal amount borrowed. Target Ltd
borrowed loans as follows:
(a) Rs. 10 lacs for a term of 5 years
(b) Rs. 8 lacs for a term of 3 years.

Compute the fair value upon initial recognition of the loan in books of Target Ltd. and how will loan processing fee be
accounted?
Solution
The loans from ABC Bank carry interest @ 10% and 12% for 5 year term and 3 year term respectively. Additionally, there is a
processing fee payable @ 1% on the principal amount on date of transaction. It is assumed that ABC Bank charges all customers
in a similar manner and hence, this is representative of the market rate of interest.
Amortised cost is computed by discounting all future cash flows at market rate of interest. Further, any transaction fees that are
an integral part of the transaction are adjusted in the effective interest rate and recognised over the term of the instrument.
Hence, loan processing fees shall be reduced from the principal amount to arrive the value on day 1 upon initial recognition.

Fair value (5 year term loan) = 10,00,000 – 10,000 (1%*10,00,000) = 9,90,000

Fair value (3 year term loan) = 8,00,000 – 8,000 (1%*8,00,000) = 7,92,000.

Now, effective interest rate shall be higher than the interest rate of 10% and 12% on 5 year loan and 3 year loan
respectively, so that the processing fees gets recognised as interest over the respective term of loans.

Illustration 12: Deposits carrying off-market rate of interest:

Containers Ltd provides containers for use by customers for multiple purposes. The containers are returnable at the
end of the service contract period (3 years) between Containers Ltd and its customers. In addition to the monthly
charge, there is a security deposit that each customer makes with Containers Ltd for Rs. 10,000 per container and such
deposit is refundable when the service contract terminates. Deposits do not carry any interest. Analyse the fair value
upon initial recognition in books of customers leasing containers. Market rate of interest for 3 year loan is 7% per
annum.
Solution
In the above case, lessee (ie, customers leasing the containers) make interest free deposits, which are refundable at the end of 3
years. Now, this money if it was to lent to a third party would fetch interest @ 7% per annum.
Hence, discounting all future cash flows (ie, Rs. 10,000)

Fair value on initial recognition = 10,000/ (1+0.07)3 = 8,163. Differential on day 1 = 10,000 – 8,163 = 1,837

The differential on day 1 shall be treated as follows:

Scenario 1 – If fair valuation is determined using level 1 inputs or other observable inputs, difference on day 1 recognised in
profit or loss
Scenario 2 – If fair valuation is determined using other inputs, difference on day 1 shall be recognised in profit or loss unless it
meets definition of an asset or liability.
In the above case, the fair valuation is made based on unobservable inputs and hence applying scenario 2, difference
can be recognised as an asset if it meets the definition. Now, since the lessee gets to use the containers in return for
making an interest free deposit plus monthly charges, the lost interest representing day 1 difference between value of
deposit and its fair value is like ‘’prepaid lease rent’ and can be recognised as such. Prepaid rent shall be charged off to
profit or loss in a straight lined manner as ‘lease rent’.

Illustration 13: Accounting for transaction costs on initial and subsequent measurement of a financial asset measured at
fair value with changes through other comprehensive income:
An entity acquires a financial asset for CU100 plus a purchase commission of CU2. Initially, the entity recognises the
asset at CU102. The reporting period ends one day later, when the quoted market price of the asset is CU100. If the

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FINAL KICK COACHING INSTITUTE
asset were sold, a commission of CU3 would be paid. How would transaction costs be accounted in books of the
entity?
Solution

- On that date, the entity measures the asset at CU100 (without regard to the possible commission on sale) and recognises a
loss of CU2 in other comprehensive income.

- If the financial asset is measured at fair value through other comprehensive income in accordance with Ind AS 109.4.1.2A,
the transaction costs are amortised to profit or loss using the effective interest method.

Illustration 14: Determining fair value upon initial measurement

The shareholders of Company C provide C with financing in the form of loan notes to enable it to acquire investments
in subsidiaries. The loan notes will be redeemed solely out of dividends received from these subsidiaries and become
redeemable only when C has sufficient funds to do so. In this context, 'sufficient funds' refers only to dividend receipts
from subsidiaries. Analyse the initial measurement of loan notes.

Solution
In this case –
Loan notes are repayable only then C earns returns in form of dividends from subsidiaries. Hence, C cannot be forced to obtain
additional external financing or to liquidate its investments to redeem the shareholder loans. Consequently, the loan notes are not
considered payable on demand.
Accordingly –

- Loan notes shall be initially measured at their fair value (plus transaction costs), being the present value of the expected
future cash flows, discounted using a market-related rate. The amount and timing of the expected future cash flows should
be determined on the basis of the expected dividend flow from the subsidiaries. Also, the valuation would need to take into
account possible early repayments of principal and corresponding reductions in interest expense.
- Since the loan notes are interest-free or bear lower-than-market interest, there will be a difference between the
nominal value of the loan notes - i.e. the amount granted - and their fair value on initial recognition. Because the
financing is provided by shareholders, acting in the capacity of shareholders, the resulting credit should be
reflected in equity as a shareholder contribution in C's balance sheet. Conversely, in books of shareholders, the
difference between amount invested and its fair value shall be recorded as ‘investment in C Ltd’ being
representative of the underlying relationship between shareholders and C Ltd.

Illustration 15 : Use of cost v/s fair value determination for equity instruments
Silver Ltd. has made an investment in optionally convertible preference shares (OCPS) of a Company – Bronze Ltd. at Rs. 100
per share (face value Rs. 100 per share). Silver Ltd. has an option to convert these OCPS into equity shares in the ratio of 1:1
and if such option not exercised till end of 9 years, then the shares shall be redeemable at the end of 10 years at a premium of
20%.
Analyse the measurement of this investment in books of Silver Ltd.
Solution
The classification assessment for a financial asset is done based on two characteristics:

i. Whether the contractual cash flows comprise cash flows that are solely payments of principal and interest on the
principal outstanding
ii. Entity’s business model (BM) for managing financial assets – Whether the Company’s BM is to collect cash flows;
or a BM that involves realisation of both contractual cash flows & sale of financial assets;
In all other cases, the financial assets are measured at fair value through profit or loss.

In the above case, the Holder can realise return either through conversion or redemption at the end of 10 years, hence it
does not indicate contractual cash flows that are solely payments of principal and interest. Therefore, such investment
shall be carried at fair value through profit or loss. Accordingly, the investment shall be measured at fair value
periodically with gain/ loss recorded in profit or loss.

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Illustration 16 : Accounting for assets at amortised cost

A Ltd has made a security deposit whose details are described below. Make necessary journal entries for
accounting of the deposit in the first year and last year. Assume market interest rate for a deposit for similar period to
be 12% per annum.

Particulars Details
Date of Security Deposit (Starting Date) 1-Apr-20X1
Date of Security Deposit (Finishing Date) 31-Mar-20X6
Description Lease
Total Lease Period 5 years
Discount rate 12.00%
Security deposit (A) 10,00,000
Present value factor at the 5th year 0.567427

Illustration 17 : Accounting for assets at FVTPL

A Ltd. invested in equity shares of C Ltd. on 15 th March for Rs. 10,000. Transaction costs were Rs. 500 in addition to the basic cost of
Rs. 10,000. On 31 March, the fair value of the equity shares was Rs. 11,200 and market rate of interest is 10% per annum for a 10
year loan. Pass necessary journal entries. Analyse the measurement principle and pass necessary journal entries.

Illustration 18: Accounting for assets at FVOCI

Metallics Ltd. has made an investment in equity instrument of a company – Castor Ltd. for 19% equity stake. Significant influence
not exercised. The investment was made for Rs. 5,00,000 for 10,000 equity shares on 01 April 20X1. On 30 June 20X1 the fair
value per equity share is Rs.45. The Company has taken an irrevocable option to measure such investment at fair value through
other comprehensive income.

Illustration 19 : Trade creditors at market terms

A Company purchases its raw materials from a vendor at a fixed price of Rs. 1,000 per tonne of steel. The payment terms
provide for 45 days of credit period, after which an interest of 18% per annum shall be charged. How would the creditors be
classified in books of the Company?
Solution
In the above case, creditors for purchase of steel shall be carried at amortised cost, ie, fair value of amount payable upon initial
recognition plus interest (if payment is delayed). Here, fair value upon initial recognition shall be the price per tonne, since the
transaction is at market terms between two knowledgeable parties in an arms-length transaction and hence, the transaction
price is representative of fair value.

Illustration 20
Silver Ltd. has purchased 100 ounces of gold on 10 March 20X1. The transaction provides for a price payable which is equal to
market value of 100 ounces of gold on 10 April 20X1 and shall be settled by issue of such number of equity shares as is
required to settle the aforementioned transaction price at Rs. 10 per share on 10 April 20X1. Whether this is classified as liability
or equity? Own use exemption does not apply.
Solution
In the above scenario, there is a contract for purchase of 100 ounces of gold whose consideration varies in response to changing value
of gold. Analysing this contract as a derivative –

(a) Value of contract changes in response to change in market value of gold;

(b) There is no initial net investment
(c) It will be settled at a future date, i.e. 10 April 20X1.
Since the above criteria are met, this is a derivative contract.
Now, a derivative contract that is settled in own equity other than exchange of fixed amount of cash for fixed number of shar es is
classified as ‘liability’. In this case, since the contract results in issue of variable number of shares based on transaction price to
be determined in future, hence, this shall be classified as ‘derivative financial liability’.
Per Ind AS 109.4.2.1 – A derivative financial liability shall be carried at fair value through profit or loss.

BY CA PRATIK JAGATI (7002630110,9864047095)

ANDROID APP – JAGATI DIGITAL EDUCATION (PLAY STORE)
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FINAL KICK COACHING INSTITUTE
Illustration 21
An entity is about to purchase a portfolio of fixed rate assets that will be financed by fixed rate debentures. Both financial
assets and financial liabilities are subject to the same interest rate risk that gives rise to opposite changes in fair value that tend
to offset each other. Provide your comments.
Solution
The fixed rate assets provide for contractual cash flows and based on business model of the entity, such fixed rate assets may be
classified as ‘amortised cost’ (if entity collects contractual cash flows) or fair value through other comprehensive income (FVOCI) (if
entity manages through collecting contractual cash and sale of financial assets).
In the absence of fair value option, the entity can classify the fixed rate assets as FVOCI with gains and losses on changes in fair
value recognised in other comprehensive income and fixed rate debentures at amortised cost. However, reporting both assets
and liabilities at fair value through profit and loss, ie, FVTPL corrects the measurement inconsistency and produces more
relevant information.
Hence, it may be appropriate to classify the entire group of fixed rate assets and fixed rate debentures at fair value through profit
or loss (FVTPL).

Illustration 22: Issue of borrowings with fixed rate of interest

A Ltd has made a borrowing from RBC Bank for Rs. 10,000 at a fixed interest of 12% per annum. Loan processing fees
were additionally paid for Rs. 500 and loan is payable 4 half-yearly installments of Rs. 2,500 each. Details are as
follows:
Particulars Details
Loan amount Rs. 10,000
Date of loan (Starting Date) 1-Apr-20X1
Date of loan (Finishing Date) 31-March-20X3
Description of repayment Repayment of loan starts from 30-Sept-20X1 (To be paid half
yearly)
Installment amount Rs. 2,500
Interest rate 12.00%

Illustration 23 : Issue of variable number of shares against issue of CCPS

A Ltd. issued compulsorily convertible preference shares (CCPS) at Rs. 100 each (Rs. 10 face value + Rs. 90 premium per
share) for Rs. 10,00,000. These are convertible into equity shares at the end of 10 years, where the number of equity shares to
be issued shall be determined based on fair value per equity share to be determined at the time of conversion.
Evaluate if this is financial liability or equity? What if the conversion ratio was fixed at the time of issue of such
preference shares?

Reclassification Question

Illustration 24
Bonds for ₹ 1,00,000 reclassified as FVTPL. Fair value on reclassification is ₹ 90,000. Pass the required journal entry.
Solution
Bonds at FVTPL Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at amortised cost 1,00,000

Illustration 25
Bonds for ₹ 1,00,000 reclassified as FVOCI. Fair value on reclassification is ₹ 90,000. Pass the required journal entry.
Solution
Bonds at FVOCI Dr. 90,000
OCI (Loss on reclassification) Dr. 10,000
To Bonds at amortised cost 1,00,000

BY CA PRATIK JAGATI (7002630110,9864047095)

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FINAL KICK COACHING INSTITUTE
Illustration 26
Bonds for ₹ 100,000 reclassified as Amortised cost. Fair value on reclassification is ₹ 90,000. Pass the required journal entry.
Solution
Bonds at Amortised cost Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at FVTPL 1,00,000

Illustration 27
Bonds for ₹ 100,000 reclassified as FVOCI. Fair value on reclassification is ₹ 90,000. Pass the required journal entry.
Solution
Bonds at FVOCI Dr. 90,000
Loss on reclassification Dr. 10,000
To Bonds at FVTPL 1,00,000

Illustration 28
Bonds for ₹ 100,000 reclassified as Amortised cost. Fair value on reclassification is
₹ 90,000 and ₹ 10,000 loss was recognised in OCI till date of reclassification. Pass required journal entry.
Solution
Bonds at FVOCI Dr. 10,000
To OCI - Loss on reclassification 10,000
[Being loss recognized in OCI now reversed prior to reclassification]
Bonds (Amortised cost) Dr. 100,000
To Bonds at FVOCI 100,000
[Being bonds reclassified from FVOCI to Amortised cost]

Illustration 29

Bonds for ₹ 100,000 reclassified as FVTPL. Fair value on reclassification is ₹ 90,000. Pass the required journal entry.
Solution
P&L - Loss on reclassification Dr. 10,000
To OCI - Loss on reclassification 10,000

Bonds at FVTPL Dr. 90,000

To Bonds at FVOCI 90,000

Impairment
Refer Question Bank for illustrations related to Impairment of Financial Assets .

BY CA PRATIK JAGATI (7002630110,9864047095)

ANDROID APP – JAGATI DIGITAL EDUCATION (PLAY STORE)
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FINAL KICK
UNIT 4 Recognition and Derecognition of Financial Instruments

Q. On 30th March 2020 an entity enters into an agreement to purchase afinancial assets for ₹ 1000 which is the fair value
on that date.
On Balance sheet date i.e. 31st March 2020 the fair value is ₹ 1020 and onsettlement date i.e. 02/04/2020 fair value is ₹ 1030
Pass necessary journal entries on trade date and settlement date whenthe asset acquired is measured at

a. Amortised cost

b. FVTPL

c. FVTOCI

Illustration 1: Regular way contracts: forward contracts

ST Ltd. enters into a forward contract to purchase 10 lakh shares of ABC Ltd. in a month’s time for ₹ 50 per share. This contract is
entered into witha broker, Mr. AG and not through regular trading mode in a stock exchange. The contract requires Mr. AG to deliver
the shares to ST Ltd. upon payment of agreed consideration. Shares of ABC Ltd. are traded on a stock exchange. Regular way
delivery is two days. Assess the forward contract.
Solution
In this case, the forward contract is not a regular way transaction and hence must be accounted for as a derivative i.e. between the
date of entering into the contract to the date of delivery, all fair value changes are recognised in profit or loss.
On the other hand, if the forward contract is a regular way transaction, such fair value changes are recognised in other
comprehensive income if share of ABC Ltd. are equity instruments and not held for trading.

Illustration 2: Regular way contracts: option contracts

NKT Ltd. purchases a call option in a public market permitting it to purchase 100 shares of VT Ltd. at any time over the next one
month at a price of ₹ 1,000 per share. If NKT Ltd. exercises its option, it has 7 days to settle the transaction according to regulation or
convention in the options market. VT Ltd.’s shares are traded in an active public market that requires two-day settlement.
Solution
In this case, the options contract is a regular way transaction as the settlement of the option is governed by regulation or convention in
the marketplace for options. Fair value changes between the trade date and settlement date are recognised in other comprehensive
income if share of VT Ltd. are equity instruments and not held for trading by NKT Ltd.

Illustration 3: Regular way purchase of financial asset

On 1 January 20X1, X Ltd. enters into a contract to purchase a financial asset for ₹ 10 lakhs, which is its fair value on trade date. On 4
January 20X1 (settlement date), the fair value of the asset is ₹ 10.5 lakhs. The amounts to be recorded for the financial asset will depend
on how it is classified and whether trade date or settlement date accounting is used. Pass necessary journal entries.

Illustration 4: Part of a financial asset

State whether the derecognition principles will be applied or not.

i. Interest strip of an interest-bearing financial asset i.e. the part entitles its holder to interest cash flows of a financial asset

ii. Dividend strip of an equity share i.e. the part entitles its holder to only dividends arising from an equity share

iii. Cash flows (principal and asset) upto a certain tenure or first right on a proportion of cash flows of an amortising financial asset.
Say, the part entitles its holder to first 80% of the cash flows or cash flows for first 4of the 6 years’ tenure.

Illustration 5: Part of a financial asset

State whether the derecognition principles will be applied or not.

i. Entity Y transfers the rights to the first or the last 90 per cent of cash collections from a financial asset (or a group of financial
assets)

ii. Entity Z transfers the rights to 90 per cent of the cash flows from a group of receivables, but provides a guarantee to
compensate the buyer for any credit losses up to 8 per cent of the principal amount of the receivables.

BY CA PRATIK JAGATI (702630110,9864047095) 20

Final Kick
In the above circumstances, Entity Y and Entity Z need to apply the derecognition requirements to the financial asset (or a group of
similar financial assets) in its entirety.

Illustration 6: Proportionate “pass through” arrangement

Entity A makes a five-year interest-bearing loan (the 'original asset') of ₹ 100 crores to Entity
B. Entity A settles a Trust and transfers the loan to that Trust. The Trust issues participatory notes to an investor, Entity C, that entitle the
investor to the cash flows from the asset.
As per Trust’s agreement with Entity C, in exchange for a cash payment of ₹
90 crores, Trust will pass to Entity C 90% of all principal and interest payments collected from Entity B (as, when and if collected). Trust
accepts no obligation to make any payments to Entity C other than 90% of exactly what has been received from Entity B. Trust provides
no guarantee to Entity C about the performance of the loan and has no rights to retain 90% of the cash collected from Entity B nor
any obligation to pay cash to EntityC if cash has not been received from Entity B. Compute the amount to be dercognised.
Solution
If the three conditions are met, the proportion sold is derecognised, provided the entity has transferred substantially all the risks and
rewards of ownership. Thus, Entity A would report a loan asset of ₹ 10 crores and derecognise ₹ 90 crores.

Illustration 7: Repurchase agreements

A financial asset is sold under repurchase agreement. The repurchase price as per that agreement is (a) fixed price or (b) sale price
plus a lender's return. Let’s look at three alternate scenarios:

i. Repurchase agreement is for the same financial asset.

ii. Repurchase agreement is for substantially the same asset

iii. Repurchase agreement provides the transferee a right to substitute assets that are similar and of equal fair value to the
transferred asset at the repurchase date.
State whether the derecognition principles will be applied or not.

Solution
In each of these scenarios, the transferred financial asset is not derecognised because the transferor retains substantially all the risks
and rewards of ownership.
Let’s look at another scenario:

Repurchase agreement provides the transferor only a right of first refusal to repurchase the transferred asset at fair value if the
transferee subsequently sells it

In this scenario, the transferred financial asset is derecognised because the transferor has transferred substantially all the risks and
rewards ofownership.

Illustration 8: Put options on transferred financial assets

A financial asset is sold and the transferee has a put option. Let’s look atsome alternate scenarios:

i. Put option is deeply in the money

ii. Put option is deeply out of the money.

State whether the derecognition principles will be applied or not.

Solution
In the first scenario, the transferred asset does not qualify for derecognition because the transferor has retained substantially all the
risks and rewards of ownership. However, in the second scenario, the transferor has transferred substantially all the risks and rewards
of ownership.

BY CA PRATIK JAGATI (702630110,9864047095) 23

Final Kick
Illustration 9: Call options on transferred financial assets
A financial asset is sold and the transferor has a call option. Let’s look atsome alternate scenarios:
i. Call option is deeply in the money

ii Call option is deeply out of the money.

What it the transferor holds a call option on an asset that is readilyobtainable in the market?

iii Call option is neither deeply in the money nor deeply out of the money State whether thederecognition principles will be
applied or not.
Solution
In the first scenario, the transferred asset does not qualify for derecognition because the transferor has retained substantially all the risks
and rewards of ownership. However, in the second scenario, the transferor has transferred substantially all the risks and rewards of
ownership.
In the third scenario, the asset is derecognised. This is because the entity (i) has neither retained nor transferred substantially all the
risks and rewardsof ownership, and (ii) has not retained control.

Illustration 10: Amortising interest rate swaps

An entity may transfer to a transferee a fixed rate financial asset that is paid off over time, and enter into an amortising interest
rate swap withthe transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount.
Scenarios:

i. Notional amount of the swap amortises so that it equals the principal amount of the transferred financial asset outstanding at any
point in time.

ii. Amortisation of the notional amount of the swap is not linked to the principal amount outstanding of the transferred asset.
State whether the derecognition principles will be applied or not.

Solution
In the first scenario, the swap would generally result in the entity retaining substantial prepayment risk, in which case the entity either
continues to recognise all of the transferred asset or continues to recognise the transferred asset to the extent of its continuing
involvement.
Such a swap would not result in the entity retaining prepayment risk onthe asset. Hence, it would not preclude derecognition of
the transferredasset provided the payments on the swap are not conditional on interest payments being made on the transferred asset
and the swap does not result in the entity retaining any other significant risks and rewards of ownership on the transferred asset.

11: Assignment of receivables

ST Ltd. assigns its trade receivables to AT Ltd. The carrying amount of the receivables is
₹ 10,00,000. The consideration received in exchange of this assignment is ₹ 9,00,000. Customers have been instructed to deposit the
amounts directly in a bank account for the benefit of AT Ltd. AT Ltd. has no recourse to ST Ltd. in case of any shortfalls in collections.
State whether the derecognition principles will be applied or not.

Solution
In this situation, ST Ltd. has transferred the rights to contractual cash flows and has also transferred substantially all the risks and
rewards of ownership (credit risk being the most significant risk in this situation).
Accordingly, ST Ltd. derecognises the financial asset and recognises ₹ 1,00,000, the difference between consideration received and
carrying amount, as an expense in the statement of profit or loss.

Illustration 12A: Debt factoring with recourse – continuing involvement asset

Entity C agrees with factoring company D to enter into a debt factoring arrangement. Under the terms of the arrangement, the factoring
company B agrees to pay ₹ 91.5 crores, less a servicing charge of ₹ 1.5 crores (net proceeds of ₹ 90 crores), in exchange for 100% of
the cash flows from short- term receivables.
The receivables have a face value of ₹ 100 crores and carrying amount of ₹ 95crores.

BY CA PRATIK JAGATI (702630110,9864047095) 23

Final Kick
The customers will be instructed to pay the amounts owed into a bank account of the factoring company. Entity C also writes a
guarantee to the factoring company under which it will reimburse any credit losses upto ₹ 5 crores, over and above the expected credit
losses of ₹ 5 crores and losses of up to ₹ 15 crores are considered reasonably possible. The guarantee is estimated to have a fair value of
₹ 0.5 crores. Comment.

Illustration 12B: Debt factoring with recourse – associated liability

Continuing illustration 12A, the associated liability is recognised at ₹ 5.5crores, as below:

i. the guarantee amount (i.e. ₹ 5 crores) plus

ii. the fair value of the guarantee (i.e. ₹ 0.5 crores). Comment

Illustration 12C: Debt factoring with recourse – gain or loss onderecognition

Pass the necessary Journal Entry.

BY CA PRATIK JAGATI (702630110,9864047095) 23

FINAL KICK
Example of Extinguishment Accounting
On 1 January 2000, Xyz ltd issues 10 year bonds for ₹ 10,00,000 bearing interest at 10% (payable annually on 31 st December each
year). The bonds are redeemable on 31 st December 2009 for ₹ 10,00,000. No cost or fees are incurred. The effective interest rate is
therefore 10%. On 1st January 2005(after 5 years) Xyz ltd and the bondholders agree to a modification in accordance with which
1. the term is extended to 31st December 2001
2. interest payments are reduced to 5% p.a.
3. the bonds are redeemable on 31st December 2001 for ₹ 15,00,000; and
4. Legal and other fees incurred ₹ 1,00,000

Xyz ltd determines that the market interest rates on 1st January 2005 for borrowings on similar terms is 11%.

The repayment schedule for the original debt till the date of renegotiation is as below :
Date/Year ended Op. Bal Int. Accruals Cash Flows Cl. Bal
1 January 20X0 10,00,000 1,00,000 (100,000) 10,00,000
31 December 20X0 10,00,000 1,00,000 (1,00,000) 10,00,000
31 December 20X1 10,00,000 1,00,000 (1,00,000) 10,00,000
31 December 20X2 10,00,000 1,00,000 (1,00,000) 10,00,000
31 December 20X3 10,00,000 1,00,000 (1,00,000) 10,00,000
31 December 20X4 10,00,000 1,00,000 (1,00,000) 10,00,000
1 January 20X0 10,00,000 1,00,000 (100,000) 10,00,000

Example of Modification Accounting

On 1 January 2000, Xyz ltd issues 10 year bonds for ₹ 10,00,000 bearing interest at 10% (payable annually on 31 st December each
year). The bonds are redeemable on 31 st December 2009 for ₹ 10,00,000. No cost or fees are incurred. The effective interest rate is
therefore 10%. On 1st January 2005(after 5 years)Xyz ltd and the bondholders agree to a modification in accordance with which
:

1. No further interest payments are made.

2. the bonds are redeemed on the original due date (31st December 2009) for ₹16,00,000; and

3. Legal and other fees incurred ₹ 50,000

The repayment schedule for the original debt till the date of renegotiation is as below:
Date/Year ended Op. Bal Int. Accruals Cash Flows Cl. Bal
1 Jan 20X0 10,00,000 1,00,000 (100,000) 10,00,000
31 Dec 20X1 10,00,000 1,00,000 (1,00,000) 10,00,000
31 Dec 20X2 10,00,000 1,00,000 (1,00,000) 10,00,000
31 Dec 20X3 10,00,000 1,00,000 (1,00,000) 10,00,000
31 Dec 20X4 10,00,000 1,00,000 (1,00,000) 10,00,000
31 Dec 20X5 10,00,000 1,00,000 (1,00,000) 10,00,000

BY CA PRATIK JAGATI (702630110,9864047095) 24

FINAL KICK
DERIVATIVES AND EMBEDDED DERIVATIVES

ILLUSTRATIVE QUESTIONS FROM STUDY MATERIAL

Illustration 1: Prepaid interest rate swap (fixed rate payment obligationprepaid at inception)
Entity S enters into a ` 100 crores notional amount five-year pay-fixed,receive-variable interest rate swap with Counterparty C.
The interest rate of the variable part of the swap is reset on a quarterlybasis to three- month Mumbai Interbank Offer Rate
(MIBOR).
The interest rate of the fixed part of the swap is 10% p.a.

Entity S prepays its fixed obligation under the swap of ` 50 crores (` 100crores × 10% × 5 years) at inception, discounted
using market interest rates
Entity S retains the right to receive interest payments on the ` 100 croresreset quarterly based on three-month MIBOR over the
life of the swap. Analyse.

Solution

The initial net investment in the interest rate swap is significantly less than the notional amount on which the variable payments
under the variable leg will be calculated. The contract requires an initial net investment that is smaller than would be required for other
types of contracts that would be expected to have a similar response to changes in market factors, such as a variable rate bond.
Therefore, the contract fulfils the condition 'no initial net investment or an initial net investment that is smaller than would be
required for other types of contracts that would be expected to have a similar response to changes in market factors'.
Even though Entity S has no future performance obligation, the ultimate settlement of the contract is at a future date and the value of the
contract changes in response to changes in the LIBOR index. Accordingly, the contract is regarded as a derivative contract.

Illustration 2: Prepaid pay-variable, receive-fixed interest rate swap

Entity S enters into a ` 100 crores notional amount five-year pay-variable,receive-fixed interest rate swap with Counterparty
C.
The variable leg of the swap is reset on a quarterly basis to three-monthMIBOR.
The fixed interest payments under the swap are calculated as 10% of theswap's notional amount, i.e. ` 10 crores p.a.
Entity S prepays its obligation under the variable leg of the swap atinception at current market rates. Say, that amount is ` 36
crores.
It retains the right to receive fixed interest payments of 10% on ` 100 croresevery year. Analyse.

Solution
In effect, this contract results in an initial net investment of ` 36 crores whichyields a cash inflow of ` 10 crores every year, for five
years. By discharging the obligation to pay variable interest rate payments, Entity S in effect provides a loan to Counterparty C.
Therefore, all else being equal, the initial investment in the contract should equal that of other financial instruments that consist of
fixed annuities. Thus,the initial net investment in the pay-variable, receive-fixed interest rate swap is equal to the investment required
in a non- derivative contract that has a similar response to changes in market conditions.
For this reason, the instrument fails the condition 'no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a similar response to changes in market
factors'. Therefore, the contract is not accounted for as a derivative contract.

Illustration 3: Prepaid forward

Entity XYZ enters into a forward contract to purchase 1 million ordinaryshares of Entity T in one year
The current market price of T is ` 50 per share The one-year forward price of T is ` 55 per share
XYZ is required to prepay the forward contract at inception with a ` 50 million payment. Analyse.

Solution
Purchase of 1 million shares for current market price is likely to have the same response to changes in market factors as the
contract mentioned above. Accordingly, the prepaid forward contract does not meet the initial net investment criterion of a
derivative instrument.

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Illustration 4: Debt instrument with indexed repayments
Entity X issues a redeemable fixed interest rate debenture to Entity Y. Amount of interest and principal is indexed to the value
of equity instruments of Entity X
Analyse
Solution
In the given case, the host is a fixed interest rate debt instrument. The economic characteristics and risks of a debt instrument are
not closely related to those of an equity instrument.
Hence, the exposure of this hybrid instrument to changes in value of equity instruments is an embedded derivative which is
required to be separated.

The response above will not change even if the interest payment and principal repayments are indexed to a commodity index or
similar underlying.

illustration 5: Debt instrument with prepayment option

Entity PQR borrows ` 100 crores from CFDH Bank on 1 April 20X1.

Interest is payable at 12% p.a. and there is a bullet repayment of principal atthe end of the term. Term of the loan is 6 years.

The loan includes an option to prepay the loan at 1st April each year with a

prepayment penalty of 3%. There are no transaction costs.

Without the prepayment option, the interest rate quoted by bank is 11% p.a.Analyse
Solution
Step 1: Identify the host contract and embedded derivative, if any
In the given case,

• Host is a debt instrument comprising annual interest payment at 12% p.a.and bullet principal repayment at the end of 6
years.

• Option to prepay the debt at `103 crores is an embedded derivative

Step 2: Determine the amortised cost of the host debt instrument
Whether the prepayment option is likely to be exercised or not, the amortised cost of the host debt instrument should be
calculated as present value (PV) of expected cash flows using a fair market interest rate for a debt without the prepayment
option (11% p.a. in this case). This is calculated below as ` 104.23 crores:

In Crores
Year Cash outflow PV @ 11% p.a. Finance cost Amortised cost
1 12.00 10.81 11.46 103.68
2 12.00 9.74 11.41 103.09

3 12.00 8.77 11.34 102.43

4 12.00 7.90 11.27 101.70

5 12.00 7.12 11.20 100.90

6 112.00 59.88 11.10 -
104.22 67.78

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Step 3: Compare the exercise price of the prepayment option with the amortised cost of the host debt instrument

Year Amortised cost Exercise price of Difference

prepayment option

1 103.68 103.00 0.7%

2 103.09 103.00 0.1%

3 102.43 103.00 -0.6%
4 101.70 103.00 -1.3%
5 100.90 103.00 -2.1%
6 - N/A

The management of Entity PQR may formulate an appropriate accounting policy to determine what constitutes “approximately
equal”. In this case, if the management determines that a difference of more than 2% will indicate that the option's exercise price is
not approximately equal to the amortised cost of the host debt instrument, it will need to separate the embedded derivative and
account for it as per principles given in the subsequent sub- section.
It may be questioned as to why an option to repay a fixed rate loan early meets the definition of embedded derivative. Let us revisit
an important phrase from the definition of embedded derivative:
“…some or all of the cash flows that otherwise would be required by the contract to be modified…”

In the context of a fixed rate debt, it may be interpreted that:

• the option affects cash flows only if exercised; and

• the cash flows of a fixed rate debt do not vary with interest rates. However, in this context, a variation in cash flows
should be interpreted asa possible change in the fair value of expected cash flows. Accordingly,

the option's expected cash flows vary according to interest rates in a

similar way as a separate option to purchase a fixed rate debt asset at a fixed price. A fixed price option to prepay a fixed rate
loan will increase in value as interest rates decline (and vice versa).

Illustration 6: Purchase contract settled in a foreign currency

On 1 January 20X1, ABG Pvt. Ltd., a company incorporated in India entersinto a contract to buy solar panels from A&A Associates,
a firm domiciled in UAE, for which delivery is due after 6 months i.e. on 30 June 20X1
The purchase price for solar panels is US$ 50 million.

The functional currency of ABG is Indian Rupees (INR) and of A&A is Dirhams.

The obligation to settle the contract in US Dollars has been evaluated to be an embedded derivative which is not closely related to
the host purchase contract.
Exchange rates:

Spot rate on 1 January 20X1: USD 1 = INR 60

Six-month forward rate on 1 January 20X1: USD 1 = INR 65Spot rate on 30 June 20X1: USD 1 =
INR 66
Analyse

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IND AS 103 QUESTIONS

Illustration 1: Asset acquisition

An entity acquires an equipment and a patent in exchange for Rs. 1,000 crore cash and land. The fair value of the land is Rs.
400 crore and its carrying value is Rs. 100 crore. The fair values of the equipment and patent are estimated to be Rs. 500
crore and Rs. 1,000 crore, respectively. The equipment and patent relate to a product that has just recently been
commercialised. The market for this product is still developing.
Assume the entity incurred no transaction costs. For ease of convenience, the tax consequences on the gain have been
ignored. How should the transaction be accounted for?
Solution
As per paragraph 2(b) of Ind AS 103, the standard does not apply to
the acquisition of an asset or a group of assets that does not constitute a business. In such cases the acquirer shall identify
and recognise the individual identifiable assets acquired (including those assets that meet the definition of, and recognition
criteria for, intangible assets in Ind AS 38, Intangible Assets) and liabilities assumed. The cost of the group shall be allocated
to the individual identifiable assets and liabilities on the basis of their relative fair values at the date of purchase. Such a
transaction or event does not give rise to goodwill‖. In the given case, the acquisition of equipment and patent does not
represent acquisition of a business.
The cost of the asset acquisition is determined based on the fair value of the assets given, unless the fair value of the assets
received is more reliably determinable. In the given case, the fair value measurement of the land appears more reliable than the
fair value estimate of the equipment and patent. Thus, the entity should record the acquisition of the equipment and patent
as Rs. 1,400 crore (the total fair value of the consideration transferred).
Thus, the fair value of the consideration given, i.e., Rs. 1,400 crore is allocated to the individual assets acquired based on their
relative estimated fair values. The entity should record a gain of Rs. 300 crore for the difference between the fair value and
carrying value of the land.
The equipment is recorded at its relative fair value ((Rs. 500 / Rs. 1,500) × Rs. 1,400 = Rs. 467 crore). The patent is recorded at
its relativefair value ((Rs. 1,000 / Rs. 1,500) × Rs. 1,400 = Rs.933 Crore).

Illustration 2
Company A is a pharmaceutical company. Since inception, the Company had been conducting in-house research and
development activities through its skilled workforce and recently obtained an intellectual property right (IPR) in the form of
patents over certain drugs. The Company‘s has a production plant that has recently obtained regulatory approvals. However,
the Company has not earned any revenue so far and does not have any customer contracts for sale of goods. Company B
acquires Company A.
Does Company A constitute a business in accordance with Ind AS 103?
Solution
The definition of business requires existence of inputs and processes. In this case, the skilled workforce, manufacturing plant
and IPR, along with strategic and operational processes constitutes the inputs and processes in line with the requirements of
Ind AS 103.
When the said inputs and processes are applied as an integrated set, the Company A will be capable of producing outputs;
the fact that the Company A currently does not have revenue is not relevant to the analysis of the definition of business under
Ind AS 103. Basis this and presuming that Company A would have been able to obtain access to customers that will purchase
the outputs, the present case can be said to constitute a business as per Ind AS 103.

Illustration 3
Modifying the above illustration, if Company A had revenue contracts and a sales force, such that Company B acquires all the
inputs and processes other than the sales force, then whether the definition of the business is met in accordance with Ind AS
103?
Solution
Though the sales force has not been taken over, however, if the missing inputs (i.e., sales force) can be easily replicated
or obtained by the market participant to generate output, it may be concluded that Company A has acquired business. Further, if
Company B is also into similar line of business, then the existing sales force of Company B may also be relevant to mitigate
the missing input. As such, the definition of business is met in accordance with Ind AS 103.

Illustration 4: Potential voting rights

Company P Ltd., a manufacturer of textile products, acquires 40,000 of the equity shares of Company X (a
manufacturer of complementary products) out of 1,00,000 shares in issue. As part of the same agreement, Company P
purchases an option to acquire an additional 25,000 shares. The option is exercisable at any time in the next 12 months. The
exercise price includes a small premium to the market price at the transaction date.
After the above transaction, the shareholdings of Company P‘s two other original shareholders are 35,000 and 25,000. Each
of these shareholders also has currently exercisable options to acquire 2,000 additional shares. Assess whether control is
acquired by Company P.
Solution
In assessing whether it has obtained control over Company X, Company P should consider not only the 40,000 shares
it owns but also its option to acquire another 25,000 shares (a so-called potentialvoting right). In this assessment, the specific
terms and conditions of the option agreement and other factors are considered:
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1. the options are currently exercisable and there are no other required conditions before such options can be
exercised
2. if exercised, these options would increase Company P‘s ownership to a controlling interest of over 50% before
considering other shareholders‘ potential voting rights (65,000 shares out of a total of 1,25,000 shares)
3. although other shareholders also have potential voting rights, if all options are exercised Company P will still own a majority
(65,000 shares out of 1,29,000 shares)
4. the premium included in the exercise price makes the options out- of-the-money. However, the fact that the
premium is small and the options could confer majority ownership indicates that the potential voting rights have
economic substance.
By considering all the above factors, Company P concludes that with the acquisition of the 40,000 shares together with the
potential voting rights, it has obtained control of Company X.

Illustration 5
ABC Ltd. incorporated a company Super Ltd. to acquire 100% sharesof another entity Focus Ltd. (and therefore to obtain
control of the Focus Ltd.). To fund the purchase, Super Ltd. acquired a loan from XYZ Bank at commercial interest rates.
The loan funds are used by Super Ltd. to acquire entire voting shares of Focus Ltd. at fair value in an orderly transaction.
Post the acquisition, Super Ltd. has the ability to elect or appoint or to remove a majority of the members of the governing
body of the Focus Ltd. and also Super Ltd.‘s management is in a power where it will be able to dominate the management of
the Focus Ltd. Can Super Ltd. be identified as the acquirer in this business combination?
Solution
Paragraph 6 of Ind AS 103 states that for each business combination, one of the combining entities shall be identified as the
acquirer.
While paragraph 7 states that the guidance in Ind AS 110 shall be used to identify the acquirer that is the entity that obtains
control of another entity called the acquiree. If a business combination has occurred but applying the guidance in Ind AS 110
does not clearly indicate which of the combining entities is the acquirer, the factors in paragraphs B14–B18 of Ind AS 103
shall be considered in making that determination.
Further, paragraph B15 provides that, in a business combination effected primarily by exchanging equity interests, the
acquirer is usually the entity that issues its equity interests. However, in some business combinations, commonly called ‗reverse
acquisitions‘, the issuing entity is the acquiree. Other pertinent facts and circumstances shall also be considered in identifying
the acquirer in a business combination effected by exchanging equity interests, including:
(a) The relative voting rights in the combined entity after the business combination: The acquirer is usually the
combining entity whose owners as a group retain or receive the largest portion of the voting rights in the
combined entity. In determining which group of owners retains or receives the
largest portion of the voting rights, an entity shall consider the existence of any unusual or special voting
arrangements and options, warrants or convertible securities.
(b) The existence of a large minority voting interest in the combined entity if no other owner or organised
group of owners has a significant voting interest: The acquirer is usually the combining entity whose single owner
or organised group of owners holds the largest minority voting interest in the combined entity.
(c) The composition of the governing body of the combined entity: The acquirer is usually the combining entity
whose owners have the ability to elect or appoint or to remove a majority of the members of the governing body of
the combined entity.
(d) The composition of the senior management of the combined entity: The acquirer is usually the combining entity
whose (former) management dominates the management of the combined entity.

(e) The terms of the exchange of equity interests: The acquirer is usually the combining entity that pays a premium over
the pre- combination fair value of the equity interests of the other combining entity or entities.
The key drivers of the accounting are identifying the party on whose behalf the new entity has been formed and identifying the
business acquired. In this scenario, as Super Ltd. has the ability to elect or appoint or to remove a majority of the members of
the governing body of the Focus Ltd. and has the ability to dominate the management of the Focus Ltd. Accordingly, Super
Ltd. will be identified as the acquirer unless there are conditions to conclude to the contrary.

Illustration 6
Can an acquiring entity account for a business combination based on a signed non-binding letter of intent where the
exchange of consideration and other conditions are expected to be completed with2 months?
Solution;
No. as per the requirement of the standard a non- binding Letter of Intent (LOI) does not effectively transfer control and
hence this cannot be considered as the basis for determining the acquisitiondate.

Illustration 7

On 1st April, X Ltd. agrees to acquire the share of B Ltd. in an all equity deal. As per the binding agreement X Ltd. will get
the effective control on 1st April. However, the consideration will be paid only when the shareholders‘ approval is received.
The shareholders meeting is scheduled to happen on 30 th April. If the shareholders‘ approval is not received for issue of new
shares, then the consideration will be settled in cash. What is the acquisition date?

BY CA PRATIK JAGATI(7002630110,9864047095) 29