This document discusses the classification and measurement of financial assets and liabilities under IAS 39. It explains that financial assets are classified into four categories: (i) fair value through profit or loss, (ii) held to maturity, (iii) loans and receivables, and (iv) available for sale. It provides details on the criteria for each classification and discusses examples of different financial instruments that could fall under each category. The document also discusses the measurement approaches for financial instruments, including initial measurement at fair value plus transaction costs and subsequent measurement using amortized cost or fair value depending on the classification.

1. Financial Assets
&
Financial Liabilities

2. IAS 39 :Classification of Financial
Assets
• Financial Assets
are classified into
four categories –
(i) Financial assets
or liability at fair
value through
profit or loss,
(ii) Held to maturity
instruments ,
(iii) Loans and
receivables and
(iv) Available for sale.

3. Financial Asset or Liability at Fair Value
through Profit and Loss
• It is classified as held for trading instrument. The
following items are defined as held for trading –
– financial asset or financial liability which are acquired or
incurred principally for the purpose of selling or repurchasing
in the near term,
– part of the portfolio of identified financial instruments that are
managed together , and for which there is evidence of recent
short term and actual profit taking ; and
– a derivative other than a financial guarantee contract or
instruments which are designated as effective hedging
instrument.
• An entity designates this type of financial instruments
as at fair value through profit or loss ( FVTPL) upon
initial recognition .

4. Portfolio Balancing
• Case Problem : A investment company holds a portfolio of debt and
equity instruments. As per the investment strategy , it holds equity
in the range of 50-60% , debt instruments in the range of 20-30%
and cash holding is no less than 10% in any point of time and should
be in the range 10 – 30%. Accordingly, the fund manager buy or sell
equity and debt instruments from time to time for re-balancing the
portfolio which of course results in short-term profit / loss. Can this
act of portfolio re-balancing be termed as short-term profit taking ?
Should the portfolio be classified as held for trading ?
• Analysis : There can be different view point on this issue. It may be
argued that it is risk management strategy. But this practice gives
rise to short-term profit taking. If this practice is continuously
followed the act of rebalancing should be definitely termed as short-
term profit taking. It is necessary to evaluate past practice.
Classification of the portfolio as held for trading will follow as a
consequence.

5. Financial Asset or Liability at Fair Value
through Profit and Loss….
• An entity can classify financial instruments with
one or more embedded derivative as FVTPL
under Para 11A of IAS 39
• A financial instrument may contain one or more
embedded derivatives. The entire hybrid
instrument may be classified as FVTPL
• A financial instrument is also designated as
FVTPL if such a designation results in more
relevant information.

6. Relevant Information basis of designating
FVTPL
• Even if a financial asset or financial liability is not FVTPL as per the
three criteria stated in the definition, it can be classified as FVTPL if
either of the two conditions are fulfilled :
– Elimination of accounting mismatch : That designation
eliminates or significantly reduces the ‘accounting mismatch’.
The term ‘ accounting mismatch signifies elimination or reduction
of inconsistencies of measurement and recognition applying
different bases ( like amortised cost ) and recognising gains or
losses ( like recognising in other comprehensive income rather
than in the income statement).
– Risk Management approach : A group of financial assets or
financial liabilities are managed together and performance
evaluation is carried out on fair value basis. This practice has
been documented in the risk management policy or investment
strategy of the entity. This basis is also used for internal reporting
to the key managerial personnel.

7. Financial liabilities designated as
FVTPL
• The following financial liabilities are classified
as held for trading –
– Liabilities for derivatives which are not hedging
instruments;
– Obligation to deliver financial asset by short seller
which is borrowed ;
– Financial liabilities that are incurred with an
intention to repurchase them in near term ;
– Financial liabilities which are portfolio which are
managed together for short term profit taking.

8. FVTPL financial assets and financial
liabilities
• Refer to Table 3.1 of Chapter 3 of Accounting
for Financial Instruments for AT A GLANCE
view of the financial assets and financial
liabilities that can be designated as FVTPL
• Chapter 3 of Accounting for Financial
Instruments for AT A GLANCE view of FVTPL
classification for the purpose of portfolio
balancing

9. Held To Maturity Investments
• These are non – derivative financial assets with fixed or
determinable payment and fixed maturity , and the entity
has the positive intent and ability to hold them till
maturity. Excluded from these are instruments which are
designated upon initial recognition as FVTPL or
available for sale or which meet the definition of loans
and receivables
• An equity instrument cannot be classified by the holder
as held to maturity ( HTM) as it has no fixed maturity. But
investment in redeemable preference shares , loans ,
debentures , etc. may be classified as HTM financial
asset if other conditions are satisfied.

10. Conditions for HTM classification
• An entity may classify a financial asset as held to
maturity if it has the positive intention and ability to
hold the asset till maturity.
• The intention should be supported financial resources
demonstrating ability to continue the investment till
maturity. Also the existing legal and other constraints
might affect the entity’s intention. The following
circumstances does not substantiate positive
intention to hold a financial asset till maturity :
• if the entity intends to hold the asset for undefined period , it does
not show the intention ;
• if the entity intends to sell the asset in response to change in
market price;
• if the issuer has right to settle the instrument significantly below
its amortised cost.

11. Amrotised cost
• The amortised cost of a financial asset or financial
liability is the amount at which the financial asset
or financial liability is measured at initial
recognition minus principal repayments, plus or
minus the cumulative amortisation using the
effective interest method of any difference
between that initial amount and the maturity
amount, and minus any reduction (directly or
through the use of an allowance account) for
impairment or uncollectibility.

12. Amortised cost…
• It is internal rate of return ( IRR) of the cash flow of the
financial instrument. Transaction costs (which are
directly attributable to acquisition or issuance of the
financial instruments are included in the cash flow.
Similarly, premium / discount on issue or redemption
are included in the cash flow. Effect of other
contractual terms of the instrument like prepayment,
embedded options are adjusted. However, normally no
adjustment is carried out for possible credit loss. A
deep discount bond often issued at price that takes
care of interest as well as credit risk factor . For this
type of instrument cash flow is not adjusted for credit
risk factor while computing effective interest rate .

13. HTM Classification Example
• [ Can puttable bonds be classified as HTM financial asset by
the holder?] ABC Ltd. issues 10,00,000 9 % 10 year Rs. 100
bond purchased at 99.5. Bonds grants put option to the
holder at the end 5 years at which point the holder can
redeem them at Rs. 101 . These bonds are repayable at Rs.
102 at maturity.
• XYZ Ltd. holds 10, 000 of these bonds issued by ABC Ltd. The
holder wishes to classify this financial asset as held to
maturity. Advice the company. How should the holder
account for the financial asset ? Should the holder segregate
the embedded put option ?
•

14. Classification of Puttable Bond as HTM
financial asset
• As per Paragraph AG 19, IAS 39 , a puttbale
bond cannot be classified as HTM financial assets.
The holder has paid for put feature. It is
inconsistent with the principle that the holder
has the intention to hold the asset till maturity.
Put option on the bond closely follows the same
interest rate risk that the underlying financial
asset is subjected to.
• So embedded derivative is not required to be
segregated. The holder can classify the financial
asset as FVTPL or available for sale.

15. Classification of Callable bond as HTM
financial assets
• [ Can callable bonds be classified as held to
maturity financial asset by the holder ? ] K Ltd.
holds 1000 9 % 10 year Rs. 100 bond purchased
at 99.5. Bonds grant call option to the issuer at
the end 5th year when the issuer can redeem
them at Rs. 100.50 . These bonds are repayable at
Rs. 101 at maturity. K Ltd. has spent Re. 0.20 per
bond on account of acquisition cost. K Ltd.
wishes to classify this financial asset as held to
maturity. Advice the company.

16. Classification of Callable bond as HTM
financial assets
• Callable bond can be classified as HTM by the holder –
(i) if the holder intends and is able to hold it until it is called or until maturity
; and
(ii) the holder would recover substantially all of its carrying amount.
• Exercise of the call option has the effect of accelerating the maturity.
Ultimate test is ability of the holder to recover substantially all of its
carrying amount by the call date. The holder has to include any premium
paid and capitalised transaction costs in determining whether the carrying
amount would be substantially recovered. The cost recovery issue is
discussed further in Example 3.12.
• The written call option on the bond closely follow the same interest rate
risk that the underlying is subjected to. So embedded derivative is not
required to be segregated. Refer Chapter 13 for a detailed discussion on
embedded derivatives.

17. HTM Classification : Tainting Rule
• An entity is not permitted at classify a financial instrument as held
to maturity ( HTM) financial asset , if there is a past evidence of
selling or re-classification of a significant portion of HTM assets .
The past evidence is evaluated based on the data of the current
year and immediately preceding two financial years.
• Three exceptions to the tainting rule :
• The entity sold HTM assets close to their maturity or call
date such that no substantial price change was expected;
• The entity sold HTM assets after it collected all substantial
payment and prepayments;
• Such selling or re-classification is attributable to isolated
and non-recurring event beyond the control of the entity.

18. Relaxation of the Tainting Rule
• Selling of a HTM financial asset in the
following circumstances does not prohibit an
entity from classifying a new financial asset as
HTM :
• HTM assets were sold because of significant deterioration
of creditworthiness of the issuer ;
• Change in tax law that eliminates or reduces tax exempt
status of HTM assets;
• Sale arising out of major business combination;
• Change in statutory requirements;
• Change in capital requirement for HTM assets;
• Significant increase in risk weights.

19. Consequence of Selling HTM Assets falling
within tainting rule
• There is more stringent rule for the existing HTM
financial assets of such an entity which sells more than
significant amount of HTM financial assets during a
financial year :
i. It is required to re-classify all other HTM financial
assets as available for sale ;
ii. It cannot classify financial assets during next two
years; and
iii. For the purpose of consolidated financial statements,
the same rule will apply to all members of the Group , an
entity of Group has sold more than significant amount of
HTM financial assets ( even if such entity is located in a
different economic environment ).

20. Loans and receivables originated by
the entity
• They are non- derivative financial assets with a fixed or
determinable payments and which are not quoted in an
active market.
• These items do not include which are originated with an
intent to be sold immediately or in the short run - if so,
they should classified as held for trading.
• Similarly, financial assets which are initially recognised
as available for sale are excluded from the definition of
loans and receivables.
• Also if the holder of the financial may not be able to
recover all of its initial investment (other than credit
deterioration) , it is classified as available for sale.

21. Loans and receivables originated by the
entity…
ABC Ltd. grants a loan of Rs. 110 million to XYZ Ltd. which the latter will pay
after 2 years with 10% interest p.a. Analyse the following situations :
Different Situations Classification
1. ABC Ltd. intends to sell the loan in the near Held for trading
term to P Ltd. at 9% yield. The loan clause
permits the initiator to sale the loan to a third
party.
2. ABC Ltd. intends classify this loan at the Available for sale
inception as available for sale
3. ABC Ltd. intends classify this loan at the Held for Trading
inception as fair value through profit and
loss
4. Other than three cases stated above Loans and receivables

22. Are unquoted redeemable preference shares
loans and receivables to the holder?
• X Ltd. purchases 10000 7% Rs. 100 preference
shares of ABC Ltd. for Rs. 99.5 redeemable at Rs. 101
after 5 years. These preference shares are not quoted.
• Can the holder classify the financial asset (Investment
in redeemable preference shares) as loans and
receivables?
• Will the answer be different if the preference shares
are quoted ?
• What should be the accounting method if they are
classified as loans and receivables?
• Can they be classified as held to maturity asset?

23. Are unquoted redeemable preference shares
loans and receivables to the holder?
• Analysis : (i) By definition , loans and receivables are non-derivative
financial assets with fixed or determinable maturity and that are not quoted
in an active market. In case the holder does not wish to sell these
preference shares in the near term , it can classify them as loans and
receivables. These preferences shares satisfy the conditions stated in the
definition of loans and receivables as per IAS 39 , therefore, can be
classified as debt instrument in the hands of the issuer.
• (ii) If they are quoted in an active market, they can not be classified as loans
and receivables. In that case they are classified as available for sale.
• (iii) Loans and receivables are measured at fair value at initial recognition.
Any transaction cost ( directly attributable for purchase of preference
shares) are added to the fair value. In subsequent measurement, amortised
cost method ( applying effective interest rate) is followed.
• (iv) They can be classified as held to maturity as well if the intention to hold
these preference shares till maturity is satisfied. When these unquoted
preference shares are held for undefined period , they should be classified
as loans and receivables.

24. Can unquoted debentures be classified as loans and
receivables in the hands of the holder?
• X Ltd. purchases 10000 7% Rs. 100 Debentures
of ABC Ltd. for Rs. 99.5 redeemable at Rs. 101
after 5 years. These debentures are unquoted.
Can the holder classify the financial asset
(Investment in unquoted debentures) as loans
and receivables?
• Analysis : Yes. The holder has , of course, the
choice to classify them as available for sale.
Even they can be classified as HTM if conditions
are satisfied.

25. Available for sale financial assets
• They are non- derivative financial assets
other than those classified under any of
the other three categories , i.e. they are
not classified as –
– financial asset at fair value through equity ,
– held to maturity, and
– loans and receivables.

27. Measurement of Financial Instruments
• The general principle of recognising a financial asset or a financial
liability by an entity on its balance sheet : when, and only when it
becomes a party to the contractual provisions of the instrument.
• Measurement principles set out in Para 43 , IAS 39 are as follows :
– (a) A financial asset or financial liability at fair value through profit or loss
should be measured at fair value on the date of acquisition or issue.
– (b) Short-term receivables and payables with no stated interest rate
should be measured at original invoice amount if the effect of
discounting is immaterial.
– (c) Other financial assets or financial liabilities should be measured at
fair value plus/ minus transaction costs that are directly attributable to
the acquisition or issue of the financial asset or financial liability.
• When settlement date accounting is followed in respect of a
financial asset which is subsequently measured at cost or
amortised cost , the asset is initially measured at fair value on the
trade date.
• Transaction price is normally the fair value of a financial instrument.
It is the consideration given or received .

28. Accounting for transaction costs
• Transaction costs are incremental costs that are directly attributable
to the acquisition, issue or disposal of financial assets or financial
liability. The term incremental costs signifies costs which would not
have been incurred other than acquisition or disposal of financial
instruments. Transactions costs comprise of –
– fees and commissions paid to agents ( including fees and commissions
to employees acting as agents ), advisers , brokers and dealers ;
– levies by regulatory agencies and securities exchanges;
– transfer taxes and duties .
• Transaction costs do not include debt premium or discounts,
financing costs or internal management expenses.
• Premium or discounts on debt instrument is part of the fair value of
the instrument.

29. Measurement Bases of Financial Assets
Nature of Financial assets Initial recognition Subsequent measurement
Held for trading At fair value At fair value
Financial assets classified as At fair value At fair value
fair value through profit and Directly attributable Gain or loss arising out of
loss at initial recognition transaction cost is charged to change in fair value is charged
FVTPL profit and loss account profit and loss account
Available for sale At fair value plus directly At fair value
attributable transaction cost
Gain or loss arising out of
change in fair value is charged
directly to equity.
When the asset is derecognised
on sale or transfer, cumulative
gain or loss arising out of
change in fair value accounted
for in equity is transferred to
profit and loss account.

30. Measurement Bases of Financial
Assets…
Held to maturity At fair value plus At amortised cost
directly attributable Change fair value is
transaction cost not recognised
Loans and At fair value plus At amortised cost
receivables directly attributable Change fair value is
transaction cost not recognised

31. Accounting for Financial Assets
• Refer to Examples 3.8-3.12 Chapter 3
Accounting for Financial Instruments (
forthcoming)

32. IFRS 9 Classification of Financial Assets
• IFRS 9 classifies financial assets differently as compared to
IAS 39. It does not have complicated principle of held to
maturity accounting and tainting rule thereof.
• Financial assets are:
• (a) classified on the basis of the entity’s business model for
managing the financial assets and the contractual cash flow
characteristics of the financial asset.
• (b) initially measured at fair value plus, in the case of a
financial asset not at fair value through profit or loss,
particular transaction costs.
• (c) subsequently measured at amortised cost or fair value.

34. IFRS 9 Classification of Financial Assets
• A financial asset is measured at amortised cost if
both of the following conditions are met:
• (a) the asset is held within a business model
whose objective is to hold assets in order to
collect contractual cash flows.
• (b) the contractual terms of the financial asset
give rise on specified dates to cash flows that are
solely payments of principal and interest on the
principal amount outstanding. [ Paragraph
4.2,IFRS 9].

35. IFRS 9 Classification of Financial Assets
• The contractual cash flows would consist solely of
payments of principal and interest on the principal
amount outstanding ( as stated in Paragraph 4.2, IFRS
9) if they are consideration for the time value of
money and for the credit risk associated with the
principal amount outstanding during a particular
period of time.
• In case there is any other cash flows arising out of the
asset or there is a limit on the cash flows in a manner
inconsistent with payments representing principal and
interest, the financial asset does not meet the
condition stated in Paragraph 4.2(b) of IFRS 9.

37. Business Model
• The business model followed by an entity is a
critical factor for classification of financial
assets. In particular , for classifying a financial
asset at amortised cost it necessary to
evaluate whether the asset is held within a
business model whose objective is to hold
assets in order to collect contractual cash
flows.

38. Business Model…
• The business model is decided by the key managerial
personnel ( refer to IAS 24 Related Party Disclosures for
definition of the term). It is not an instrument specific
model and therefore, intention of the management as
regards a particular financial asset is not relevant.
However, it is possible to have more than one business
model.
• So the business model is neither instrument –specific
nor a broad concept to cover entity-wide model. It
simply requires a higher level of aggregation. For
example, it is possible to aggregate all loans to
employees together to evaluate the business model.

39. Business Model…
• An entity needs not hold a financial asset till maturity to satisfy the
criteria that the asset is held within a business model whose
objective is to hold assets in order to collect contractual cash flows.
An entity’s business model can be to hold financial assets to collect
contractual cash flows even when sales of some the financial assets
occur. For example, the entity may sell a financial asset if:
• (a) the financial asset no longer meets the entity’s investment
policy (e.g. the credit rating of the asset declines below that
required by the entity’s investment policy);
• (b) an insurer adjusts its investment portfolio to reflect a change in
expected duration (i.e. the expected timing of payouts); or
• (c) an entity needs to fund capital expenditures.

40. Case Analysis 1 : Business Model
• Entity E purchased 3% Debentures of € 20 million
which form part of a portfolio of financial assets having
contractual cash flows. It has adopted a business
model whose objective is to hold assets in order to
collect contractual cash flows. It evaluates among
other information, the fair value of financial assets
from a liquidity perspective (i.e. the cash amount that
would be realised if the entity needs to sell assets). It
also sold during the year certain items of financial
assets having contractual cash flows out of the
portfolio. Can the entity classify the new purchase as a
financial asset at amortised cost?

41. Solution to Case Analysis 1 : Business
Model
• An entity’s business model can be to hold financial assets to collect
contractual cash flows even when sales of financial assets occur.
• As per Paragraph B4.1.3 , IFRS 9 , infrequent sale out of the
portfolio of financial assets having contractual cash flows does not
alter the entity’s business objective. An entity may sell some of the
financial assets which no longer meets the entity’s investment
policy , or for adjusting the duration of the portfolio or to meet
fund’s capital expenditure. It can classify the new purchase as
financial asset at amortised cost.
• However, it would re-assess the business model in the light of the
objective of holding the assets for collecting contractual cash flows
when there are more than infrequent number of sales.

42. Case Analysis 2 : Business Model
• Entity E invested in corporate debentures. The
portfolio may incur credit loss, However , the
entity has adopted a business model whose
objective is to hold assets in order to collect
contractual cash flows. Can this loan portfolio
be classified as financial asset at amortised
cost ?

43. Solution to Case Analysis 2 : Business
Model
• The objective of the entity’s business model is to hold the
financial assets and collect the contractual cash flows. It
does not purchase the portfolio to make a profit by selling
them. The same analysis would apply even if the entity
does not expect to receive all of the contractual cash flows
(e.g. some of the financial assets have incurred credit
losses). So the loan portfolio can be classified as financial
assets at amortised cost. [ Paragraph B4.1.4 , IFRS 9].
• Applying the same principle , a portfolio of trade
receivables may be classified as financial asset at amortised
cost.

44. Nature of contractual Cash flows
• To be classified as a financial asset at
amortised cost , the contractual cash flows
inherent in the financial asset shall consist
solely of the payments of principal and
interest on the principal amount outstanding
for the currency in which the financial asset is
denominated.

45. Case Analysis 1 : Contractual Cash
Flows
• Entity E invested in 5 year 4% € 1000
debentures. The debentures pay interest over
8 years and repay principal after 5 years. Are
the debentures having contractual cash flows
consisting solely of principal and interest on
outstanding principal ?

46. Solution to Case Analysis 1 :
Contractual Cash Flows
• It is just readjustment of the timing of the
cash flows. If the payment satisfies the
condition of time value of money , it can be
identified as contractual cash flows consisting
solely of the principal and interest on
outstanding principal. The entity would satisfy
the condition comparing to benchmark yield
of 5 year maturity debt instrument.

47. Case Analysis 2 : Contractual Cash
Flows
• Entity E invested in 1000 5 -year floating rate
debentures of € 1000 each. However, the
interest rate cannot be higher than 6.5%. Are
the debentures having contractual cash flows
consisting solely of the principal and interest
on outstanding principal ?

48. Solution to Case Analysis 2 :
Contractual Cash Flows
• A variable rate debt instrument in which interest rate is
capped satisfies the test of having contractual cash
flows consisting solely of the principal and interest on
outstanding principal. The contractual cash flows of
both:
• (a) an instrument that has a fixed interest rate and
• (b) an instrument that has a variable interest rate
• are payments of principal and interest on the principal
amount outstanding as long as the interest reflects
consideration for the time value of money and for the
credit risk associated with the instrument during the
term of the instrument.

49. Classification of Financial Liabilities
From the perspective subsequent measurement, different types of
financial liabilities are-
• Financial liabilities at fair value through profit and loss including
stand alone derivative liabilities ;
[ Stand-alone derivatives with negative values are classified as liability.
All stand-alone derivatives are classified as FVTPL financial asset or
financial liability].
• Financial liabilities that arise when a transfer of a financial asset
does not qualify for derecognition or when the continuing
involvement approach applies ;
• Financial guarantee contracts;
• Commitments to provide a loan at a below-market interest rate;
• Liabilities at amortised cost.

50. Financial Liabilities…
• At initial recognition all financial liabilities except
FVTPL financial liabilities are measured at fair
value minus directly attributable transaction
costs. In case of FVTPL financial liabilities, directly
attributable transaction costs are separately
charged to the Statement of Profit and Loss.
• At subsequent measurement all financial
liabilities except (1)-(4) are measured at
amortised cost.

52. Accounting for Repo Transaction
• Refer to Example 4.3 of Chapter 4 Accounting
for Financial Instruments ( forthcoming)

53. Loan Commitments
• Certain loan commitments are with in the scope of IAS 39 :
• (a) An entity that has a past practice of selling the assets resulting from its loan
commitments shortly after origination shall applies IAS 39 to all its loan
commitments in the same class.
• The entity designates these loan commitments as financial liabilities at fair value
through profit or loss.
• (b) Certain loan commitments can be settled net in cash or by delivering or issuing
another financial instrument. These loan commitments are derivatives.
• A loan commitment is not regarded as settled net merely because the loan is paid
out in instalments (for example, a mortgage construction loan that is paid out in
instalments in line with the progress of construction).
• (c) Commitments to provide a loan at a below-market interest rate. They are
measured at the higher of:
• (i) the amount determined in accordance with IAS 37; and
• (ii) the amount initially recognised (see paragraph 43) less, when appropriate,
cumulative amortisation recognised in accordance with IAS 18. [ Paragraph IAS
39.47(d) ]

54. Loan Reschedulement
• Refer to Example 2.13 of Chapter 2 of
Accounting for Financial Instruments

55. Guidance to Fair Value Measurement
Issues Details
1. Basic principle Fair value measurement is based on going concern presumption. The entity
will not be able realise it in forced or distress sale.
2. Active Market Quoted Price Active market does not necessarily mean stock exchange. Availability of
regular and ready quotation for an financial asset from an exchange ,
industry group, pricing service or regulatory agency etc. means active market
quoted price.
Use of bid or ask price The appropriate quoted market price for an asset held or liability to be issued
Mid-market price should be the current bid price. The appropriate quoted market price for an
Price of recently observed asset to be acquired or liability held should be the current ask price. If the
transaction entity has financial assets and liabilities with offsetting market risk , it can
use mid-market price. In absence of current bid or ask price , the entity may
use price of most recent transaction.
Adjustment to last observed If the entity demonstrates that last observed price was not a fair market
price quotation , e.g. it was a distress sale, it can make adjustment to last observed
price. Also if there is change in conditions since the last transaction has
taken place, there is a need for adjusting the fair value.
Adjustment for credit risk This is of course adjusted by the entity for counterparty risk, country risk ,
etc. When the entity uses market yield for determining fair value of a debt
instrument , it is necessary to consider whether such rate includes credit risk
factor or not. If not, there is a need to adjust for credit risk.

56. Guidance to Fair Value Measurement..
3. Meaning of fair Price agreed by a willing buyer and willing seller in an arm’s length
value transaction.
4. Non active i. Valuation technique includes – (a) recent price of a
market valuation comparable transaction , (b) discounted cash flow ( demonstrated
technique in this chapter, (c ) application option price model .
ii. A valuation technique would be expected to arrive at a realistic
estimate of the fair value if (a) it reasonably reflects how the
market could be expected to price the instrument and (b) the
inputs to the valuation technique reasonably represent market
expectations and measures of the risk-return factors inherent in
the financial instrument.
iii. A valuation technique should therefore (a) incorporates all
factors that market participants would consider in arriving at a
price and (b) is consistent with accepted economic methodologies
for pricing financial instruments.
iv. An entity should periodically calibrates the valuation with
reference to recently observed price of comparable transaction.
v. The transaction is the best evidence of the fair value at initial
recognition.

57. Guidance to Fair Value Measurement..
4. Non- active vi. In subsequent measurement , change in fair value should arise from the
Market factors which market participants would consider in setting price.
valuation
technique.. vii. If the financial instrument is a debt instrument (such as a loan), its fair
value can be determined by reference to the market conditions that existed
at its acquisition or origination date and current market conditions or
interest rates currently charged by the entity or by others for similar debt
instruments (i.e., similar remaining maturity, cash flow pattern, currency,
credit risk, collateral and interest basis).
vii. The entity may not have same information in all measurement date.
viii. While applying discounted cash flow analysis, an entity uses one or more
discount rates equal to the prevailing rates of return for financial
instruments having substantially the same terms and characteristics,
including the credit quality of the instrument, the remaining term over
which the contractual interest rate is fixed, the remaining term to
repayment of the principal and the currency in which payments are to be
made.
ix. Short-term receivables and payables with no stated interest rate are
measured at the original invoice amount if the effect of discounting is
immaterial.

58. Regular way purchase or sale contract
• It is defined as a purchase or sale contract of financial asset whose
terms require delivery of the asset within the time frame established
generally by regulation or convention in the market place.
• The contract is not limited to transactions in formal stock or
derivative exchanges or over-the –counter exchanges. This
definition refers to broad market wherein the financial assets are
customarily exchanged.
• So delivery should be within the time frame which is reasonable and
customarily required for the parties to prepare and execute closing
documents.
• Sometimes an entity may deal in financial assets in different
exchanges wherein there are different delivery rules. The entity
should follow the delivery rule of the market in which the purchase or
sale contract has been entered into.

59. Regular way purchase or sale contract..
• A regular way purchase or sale contract is
recognised using either trade date
accounting or settlement date accounting.
• On the trade date , the entity commits to
purchase or sell the financial instrument
whereas on the settlement date , the
financial instrument is delivered to or by an
entity.

60. Trade Date Accounting
• Under trade date accounting , a financial asset
purchased is recognised on the trade date along
with simultaneous recognition of related liability
to pay for it.
• Similarly , financial asset sold is derecognised
on the trade date with recognition of gain/loss on
sale of that asset and related receivables.
• If the financial asset is an interest bearing
instrument like debt or bond, interest does not
accrue on and from the trade date.

61. Settlement date accounting
• Under settlement date accounting , a
financial asset purchased is recognised on
the settlement date along with
simultaneous recognition of related liability
to pay for it.
• Similarly , financial asset sold is
derecognised on the settlement date with
recognition of gain/loss on sale of that
asset and related receivables.

62. Application of trade date accounting for
purchase of a financial asset
• X Ltd. purchases a financial asset as on 29
March , 2008 for Rs. 10 million.
• The fair value of the asset on 31 March , 2008 (
Year End) and 1 April , 2008 ( Settlement date)
Rs. 10.5 million and Rs. 10.3 million
respectively.
• Accounting treatment of the transaction would
depend upon classification of the financial asset.

63. Trade Date Accounting …
Date Held to maturity Available for sale Assets at FVTPL
investment carried assets re-measured re-measured at
at amortised cost to fair value with fair value with
changes in equity changes in P&L
29 March ,2008
Financial Asset Dr. 10 10 10
To Financial Liability 10 10 10
31 March 2008
Financial Asset Dr. 0.5
To P & L A/c 0.5
Financial Asset Dr. 0.5
To Fair Value Reserve A/c 0.5
2 April ,2008 0.2
P& L A/c Dr. 0.2
To Financial Asset
Fair Value Reserve A/c Dr. 0.2
To Financial Asset 0.2

64. Settlement Date Accounting..
Date Held to maturity Available for sale assets Assets at FVTPL re-
investment carried at re-measured to fair measured at fair
amortised cost value with changes value with
in equity changes in P&L
29 March ,2008 No entry on trade date No entry on trade date No entry on trade date
31 March 2008 0.5
Receivables Dr. 0.5
To P & L A/c
Receivables Dr. 0.5
To Fair Value Reserve A/c 0.5
2 April ,2008
Financial Asset Dr. 10.0
To Financial Liability / Cash 10.0
Financial Asset Dr. 10.3
Fair Value Reserve A/c Dr. 0.2
To Financial Liability / Cash 10.0
To Receivables 0.5
Financial Asset Dr. 10.3
P&L A/c Dr. 0.2
To Financial Liability / Cash 10.0
To Receivables 0.5

65. Derivatives
• Derivative Instrument is defined in Paragraph 9 of IAS 39 . A
derivative contract is characterised by all the three features that -
– (i) its value changes in response to the change in specific interest rate,
financial instrument price , commodity price, foreign exchange rate,
index of price or rates , credit rating or credit index or other variables ;
however, in the case of a non-financial variable , the variable is not
specific to a party to the contract;
– (ii) it requires no initial investment or an initial net investment that is
smaller as compared to other contract to have similar response to
change in market factor ; and
– (iii) it is settled in a future date.
• Common examples of derivatives are – interest rate swap , currency
swap, commodity swap , equity swap , credit swap , total return
swap, purchased or written treasury bond option , purchased or
written currency option, purchased or written commodity option,
purchased or written stock option, interest rate futures linked to
government bond, currency futures, commodity futures , stock
futures, currency forward , commodity forward , equity forward , etc.

66. Common underlyings of derivative
contracts
Derivative contracts and underlyings
List of contracts Underlyings
1. Stock index futures / Option Benchmark index for example Nifty
2. Stock futures / options Particular equity share
3. Interest rate swap Interest rate
4. Currency swap / currency futures / Exchange rate of the currencies involved
currency option / Currency forward
5. Commodity swap / commodity futures / Commodity price
Commodity option / Commodity
forward
6. Equity swap / forward Equity price
7. Credit swap Credit rating / credit index
8. Total return swap Fair value of the reference asset
9. Interest rate futures / options / FRA Interest rate

67. Definition of Derivatives
Issues
1. An interest swap contract requires gross settlement of interest . Can it be classified
as a derivative contract under IAS 39 ?
Analysis : Net settlement is not a pre-condition of derivative
2. If fixed leg of an interest rate swap is prepaid , does it remain a derivative contract
despite of high initial investment ?
Analysis : Initial investment for prepaid fixed leg should be compared with spot
investment required to get similar floating leg position.
Present value of the prepaid fixed leg shall be lower than spot investment to get similar
floating rate exposure. So it will satisfy the initial investment test set out in Para 9 , IAS
39. It is a derivative contract.
3. If fixed leg of an interest rate swap is prepaid subsequently, does it remain a
derivative contract despite of high initial investment ?
Analysis : It is to be treated as termination of old swap and origination of a new swap.
Payment made for the balance life of the contract is equivalent to taking floating rate
position in the underlying.
If the present value of the prepaid fixed leg is lower than spot investment to get similar
floating rate exposure , then it will be classified as derivative contract.

68. Definition of Derivatives…
Issues
4. If floating leg of an interest rate swap is prepaid subsequently, does it remain a
derivative contract despite of high initial investment ?
Analysis : The first characteristic of a derivative contract that the value of the
instrument changes in response to an underlying is missing if floating leg is prepaid
( identification of the underlying and response to value change is must). It no longer
remains a derivative contract.
5. Can two non-derivative contracts be aggregated to make it a derivative contract ?
For example , can a fixed rate loan payable and a floating rate loan receivable be
offsetting ?
Analysis : Answer is in affirmative subject to fulfilment of certain critical condition.
6. Is out of the money option a derivative contract ?
Analysis : This question arises out of the settlement issue. A feature of
derivative contract is that it is settled on a future date. Settlement includes
expiry without exercise. If an out of the money expires worthless that signifies a
settlement.

69. Definition of Derivatives…
Issues
7. Is a foreign currency contract based on purchase / sales volume treated as
a derivative contract?
Analysis : Volume based foreign currency has two variables , it has no initial
investment and it is settled on future date(s). So it is a derivative.
Similarly, a basis swap contract has two variables.
8. Is prepaid forward a derivative ?
Analysis : Here issue is the initial investment. Prepaid amount should be
compared with alternative investment to get the same degree of exposures.
9. Should the initial Margin in future / option contracts be considered while
evaluation initial investment in a derivative contract ?
Analysis : Margin is just a collateral not an investment.

70. Swap Transaction
X Ltd. has entered a 5 year Pay Fixed Receive variable swap contract with a swap dealer
for a notional amount of Rs. 10 million. The swap rate is 6.5% p.a.. But the contract
requires that X would pay gross at fixed rate every Jan 1 and July 1 and receive gross at
floating rate .
Does this swap contract satisfy the definition of derivatives ?
Analysis : Yes. (i) value of the instrument changes in response to an underlying (
identification of the underlying and response to value change is must) , (ii) no initial
investment or smaller initial investment if similar value changes to be achieved through
the underlying and (iii) settlement at a future date. In view of these three criteria the
interest rate swap contract (IRS) shall be evaluated. Para 9 , IAS 39 does put gross
settlement under a derivative as disqualification.

71. Prepaid interest rate swap
• Prepaid fixed leg at the inception of the contract : In an interest rate
swap there are two legs – fixed leg and floating leg. One party pays fixed
rate in exchange the counterparty pays variable , say 6-month LIBOR. X
Ltd. enters into a pay 8% fixed receive floating swap for 4 years on notional
principal of Rs. 100 million . Settlement date is every Jan 2 and July 2. If X
Ltd. pays the present value of the fixed leg discounted at the current market
yield of 8% , the fixed leg of the swap is prepaid at the inception. Should the
contract still be considered as a derivative ?
• Analysis : Here the appropriate test is based on no initial investment or
comparatively smaller initial investment in view of large amount of initial
investment :
‘ it requires 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’.
• As an alternative X Ltd. could invest Rs. 100 million in LIBOR denominated
bond which would pay it 6- month LIBOR.
• Prepaid fixed leg = Rs. 4 million half – yearly annuity factor for 4 years
= Rs. 4 million 6.7327 = Rs. 26.93 million
• X Ltd. could get the same amount based on 6 – month LIBOR investing Rs.
26.93 million rather than Rs. 100 million. So the transaction satisfies the
requirement of comparatively smaller initial investment. It is a derivative
contract under Para 9 of IAS 39.

72. Prepaid fixed leg subsequent to the
inception of the contract
• It means cancellation of the old contract. Suppose X Ltd.
prepays the fixed leg after third six months . Then it pays
for 5 fixed instalments. If the current market yield is
8.5%, then the prepaid fixed leg is -
Rs. 4 million half – yearly annuity factor for 2.5 years
= Rs. 4 million 4.4833 = Rs. 17.93 million
• This is an one time payment ( representing a financial
asset ) to get PV of 5 instalment of expected 6-month
LIBOR on Rs. 100 million.
• The new contract will remain as a derivative as that
satisfies lower initial investment condition. Refer to IAS
39 IG B.4 which states that the new contract should be
evaluated afresh.

73. Accounting For Option
• X Ltd. purchased 1 lot of Reliance Call option, expiry 30 July 2009,
market lot 300, stock price Rs. 2348 , Strike 2340 at 242.
• As on 30 June the above-mentioned option is valued at 285
because stock price increased to Rs. 2500.
• Show accounting entries.
On 12.6.2009
Reliance Call Option Dr. 72,600
To Cash 72,600
On 30.6.2009
Reliance Call Option Dr. 12,900
To Fair Value Gain 12,900
Fair Value Gain Dr. 12,900
To Income Statement 12,900

74. Accounting For Futures
• X Ltd. purchased 1 lot of Reliance Futures, expiry 30 July 2009,
market lot 300, stock price Rs. 2348 , Future price 2368.
• As on 30 June the above-mentioned futures is valued at 2565
because stock price increased to Rs. 2500.
• Show accounting entries.
On 12.6.2009
No entry
Fair Value of the futures on the transaction is zero.
On 30.6.2009
Reliance Futures Dr. 59100
To Fair Value Gain 59100
Fair Value Gain Dr. 59100
To Income Statement 59,100

75. Accounting for Currency Forward
Forecast transaction subsequently resulting in recognised non-financial asset
X Ltd. wishes to purchase inventory amounting to US$ 10 million on 30.6.2012 .
Having apprehension of INR depreciation it has purchased 9 months US$ forward
from its banker at 49.10 on October 1,2011 when spot rate was 47.50.
Date US$/INR Spot Rate Type of forward Forward rate to
30.6.2012
October 1, 2011 47.50 9 months forward 49.10
Dec 31, 2011 47.30 6 months forward 48.80
March 31,2012 50.20 3 months forward 51.00
June 30,2012 55.00

76. Accounting for Currency Forward..
• The company designated forward contract
as hedging instrument in a cash flow
hedge of foreign exchange contract to buy
inventory.
• How should the fair value of forward be
computed ? What should be the
accounting entries? Assume applicable
yield in the local currency is 8% p.a.

77. Currency Forward Valuation
10 × [ 48.80-49.10]
31.12.2011 = -------------------------- =- 2.89
1.08 0.50
10× [ 51-49.10]
31.3.2012 = ---------------------------=18.64
1.08 0.25
30.6.2012 = 10× [ 55-49.10] = 59.00

78. Accounting
Date Particulars Amount ( Dr.) Amount ( Cr.)
Rs. in million Rs. in million
Oct 1 2011 No entry required when forward
contract is entered into
Dec. 31 2011 Cash Flow Hedge Reserve Dr. 2.89
To Forward Liability 2.89
Fair value change of the forward
contract
March 31 Forward liability Dr. 2.89
2012 Forward Asset Dr. 18.63
Cash Flow Hedge Reserve 21.52
June 30 Forward Asset Dr 40.36
2012 To Cash Flow Hedge Reserve 40.36
Gain on forward contract between
1.4.2012 to 30.6.2012
June 30 Purchases 550.00
2012 To Cash 491.00
To Forward Asset 59.00
June 30 Cash Flow Hedge Reserve Dr. 59.00
2012 To Purchase 59.00

79. Accounting for Swaps
• Refer to separate file