Financial Instruments
A comprehensive guide for accounting for financial instruments, covering presentation, recognition, and measurement.
[Ref Para 11] A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Here, Rajesh now has a contractual obligation to receive cash in the form of interest for the period of the loan and, Principal as at the end of the period and therefore has a Financial Asset, and Nikhil has a contractual Obligation to pay cash in the form of interest and Principal i.e. a Financial Liability. Hence, the Debenture contract is a Financial Instrument.
Types of Financial Instruments:
- Financial Assets
- Financial Liabilities
Author's Note: Let’s Analyze Carefully, to be a financial Instrument there needs to be a financial asset for one entity and equity for another entity, those are simply investment in equity share of a company, in case of financial liability of other entity, maybe a loan provided. By just the term “Financial instruments”, it can be understood that these are assets/Liabilities that can be easily exchanged in terms of money like loan portfolio can be sold, debenture can be sold, Equity shares can be sold, bitcoin can be sold” but are all these financial instruments. Let’s analyze Bitcoin, it can be financial asset for one entity but it cannot be an equity or liability of another entity, so even it looks like and feels like that cryptocurrencies are like cash so they should be accounted for as cash or simply a financial instrument, they are classified as Intangible assets and are mostly carried at Revalued Amount
[Ref para 11] Financial assets are any assets that are:
- Cash
- An equity instrument of another entity
- A contractual right:
- To receive cash or another financial asset from another entity; or
- To exchange financial assets or liabilities under potentially favorable conditions
- a contract that will or may be settled in the entity’s own equity instruments and is:
- a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
- a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
Tackling the Complexity
Let's tackle the complex parts of that definition one by one:
- Potentially Favorable Conditions: This means a financial asset can also arise when an entity has a contractual right to exchange one financial instrument for another in a way that is expected to be beneficial. If it's potentially unfavorable, it becomes a financial liability.
- Settled in Own Equity (Variable): This refers to contracts where an entity will receive or issue a variable number of its own shares. Because the number isn't fixed, it's treated as a financial asset or liability, not equity.
Rajesh has one share of Nabil Bank that he purchased for 955. It’s currently selling for 955 as well, and he enters into an agreement to sell that asset with Paul at 1045 in three months.
Here, Rajesh has a financial asset (the share) and a derivative contract that allows him to sell it at a potentially favorable condition, locking in a profit of 90. Paul enters this agreement expecting the share price to rise above 1045, which would make the deal profitable for him.
Rajesh Ltd. enters into a contract with Paul whereby Paul agrees to transfer goods worth NPR 1,000,000 to Rajesh Ltd. In return, Rajesh Ltd. will issue its own equity shares to Paul, but the number of shares will depend on the share price at the date of settlement (e.g., 10,000 shares if price is 100; 20,000 shares if price is 50).
Because Rajesh Ltd. is receiving assets (goods) and issuing a variable number of its own equity instruments, the contract qualifies as a financial asset/liability, not an equity instrument.
Author's Note: Why not Equity? Equity instruments require a "fixed-for-fixed" criteria: a fixed amount of cash for a fixed number of shares. Since the number of shares is variable, it cannot be classified as equity on day one, as equity is not remeasured.
On 1st April 2023, Binod enters into a call option contract with Biraj. The contract gives Binod the right to buy 100 shares of Nepal Investment Bank Ltd. (NIBL) from Biraj at NPR 1,000 per share on 1st July 2023. The premium paid is NPR 20 per share. The market price of the share is NPR 950 on the contract date. On 1st July 2023, the market price becomes NPR 1,050.
Q1: Who is the buyer and seller?
Buyer (holder): Binod, Seller (writer): Biraj
Q2: What type of derivative?
This is a Call Option.
Q3: What is Binod's right?
Binod has the right, but not the obligation, to buy 100 shares at NPR 1,000.
Q4: What was the option premium?
NPR 20 per share × 100 shares = NPR 2,000
Q5: Should Binod exercise the option?
Yes, because the market price (1,050) is higher than the strike price (1,000).
On May 31, if the FV of the Asset is 1030, this means Binod has a right to exchange that asset (share) in a potentially favorable condition and as a result, it is a financial Asset of Binod.
Author's Note: The holder of a call option can never have a financial liability from the option itself. It’s either an asset (if favorable) or an instrument with zero value (if unfavorable), since no rational person would choose to exercise an option under unfavorable circumstances.
- Trade Receivable
- Investment in Shares
- Loans Provided
- Investment in debentures
- Property, Plant and Equipment
- Intangible Assets
- Prepaid Expenses
- Deferred Tax Asset.
Financial Assets are classified into three main categories:
- Financial Assets at Amortized Cost.
- Financial Assets at Fair Value through Profit and Loss (FVTPL).
- Financial Assets at Fair Value through Other Comprehensive Income (FVTOCI).
For the purpose of classification, a test popularly known as the "SPPI Criteria Test" is used. If an asset meets the requirements of the test, it is classified as either Amortized Cost or FVTOCI. If not, it is classified as FVTPL.
SPPI stands for: 'Solely Payments of Principal and Interest'. This means an asset that has been held with the purpose to earn return through interest and principal. i.e. the asset held for the purpose to sell are classified as FVTPL which seems logical.
Classification for Assets Meeting SPPI Criteria:
Business Model:
Hold the asset to collect contractual cash flows.
E.g. Purchase of a Treasury bond by an FMCG company for a security deposit.
Business Model:
Both hold to collect contractual cash flows AND sell the financial asset.
E.g. Insurance companies generally invest in debentures with a view to earn interest but also sell may if needed.
| Classification | Fair Value Change Treatment |
|---|---|
| Amortized Cost | The Effective Interest Rate (EIR) method is followed. Changes in fair value are not considered. |
| FVTOCI | Fair value changes are recognized in Other Comprehensive Income (OCI). |
| FVTPL | Fair value changes are recognized in the Statement of Profit or Loss (SOPL). |
Author's Note: Let’s analyze the basic logic behind the classification:
- Amortized Cost: Only held to earn Interest and Principles and therefore the holder or the users do not need to know the changes in Fair Value.
- FVTOCI: Although the assets are held to collect Contractual cash Flows, it can also be sold, so Fair value changes are transferred to OCI, these will be reclassified to SOPL on sale as FV gain.
- FVTPL: The Holders and The users need is to earn profit by selling the asset rather than through contractual cash flows. FV is the only matter of concern to the users and therefore is reflected directly in SOPL.
| Financial Assets | SSPI Criteria | Business Model | Classification |
|---|---|---|---|
| Bank - Loan to Customers | Hold to collect Contractual cash Flows | Amortized Cost | |
| Securities Co. - Shares | To Sell | FVTPL | |
| Mutual Fund | Hold to collect Contractual cash Flows and Sell | FVTOCI |
| Financial Assets | SSPI Criteria | Business Model | Classification |
|---|---|---|---|
| Bank - Loan to Customers | Hold to collect Contractual cash Flows | Amortized Cost | |
| Securities Co. - Shares | To Sell | FVTPL | |
| Mutual Fund | Hold to collect Contractual cash Flows and Sell | FVTOCI |
Hamaal and Rajesh Company is a Car Dealership that invests its assets in safe debentures. It bought 10,000, 10-Year 8% Rs 1000 debentures at 994 and paid Service charge 3 per Debenture.
Initial Recognition: Financial Assets at Amortized cost are initially recognized at Total cost, including the Transaction Cost.
Financial Asset at Amortized Cost A/c Dr. 9,970,000
To Bank A/c 9,970,000
(To record purchase of 10,000 debentures @ 997 each)Subsequent Measurement
Financial Assets are subsequently accounted for using the Effective Interest Rate (EIR) method. EIR is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset to the net carrying amount of the financial asset.
| Details | Year | Cash Flows (Rs.) |
|---|---|---|
| Initial Investment - Outflow | 0 | (9,970,000.00) |
| Contractual Cash Inflows Throughout the period of the Debenture. | ||
| Annual Inflow (8% of 10M) | 1 | 800,000.00 |
| Annual Inflow (8% of 10M) | 2 | 800,000.00 |
| Annual Inflow (8% of 10M) | 3 | 800,000.00 |
| Annual Inflow (8% of 10M) | 4 | 800,000.00 |
| Annual Inflow (8% of 10M) | 5 | 800,000.00 |
| Annual Inflow (8% of 10M) | 6 | 800,000.00 |
| Annual Inflow (8% of 10M) | 7 | 800,000.00 |
| Annual Inflow (8% of 10M) | 8 | 800,000.00 |
| Annual Inflow (8% of 10M) | 9 | 800,000.00 |
| Annual Inflow (8% of 10M) | 10 | 10,800,000.00 |
Using the IRR function on these cash flows, the
Effective Interest Rate (EIR) = 8.04%
For manual calculation, the intersection method can be used.
Author's Note: Q: Why is the actual return reflected by the EIR higher than the Interest Rate (Coupon Rate)? Isn't 8% exactly what we will receive at the end of the year?
A: 8% Coupon rates are calculated at 1000 per debenture, however we purchased the debenture at a slightly lower price of 997, and therefore we obtained a higher Return than the Coupon rate.
Author's Note: Q: Then, if we had bought the Asset at 1000, would our EIR equal our Coupon?
A: Yes Exactly
How are accounting Entries passed?
Based on the EIR of 8.04%, the following schedule shows how interest income is recognized over the life of the debenture.
| Opening | Interest @ EIR | Payment Received | Closing Balance |
|---|---|---|---|
| 9,970,000.00 | 802,066.48 | (800,000.00) | 9,972,066.48 |
| 9,972,066.48 | 802,232.73 | (800,000.00) | 9,974,299.21 |
| 9,974,299.21 | 802,412.35 | (800,000.00) | 9,976,711.56 |
| 9,976,711.56 | 802,606.41 | (800,000.00) | 9,979,317.97 |
| 9,979,317.97 | 802,816.10 | (800,000.00) | 9,982,134.07 |
| 9,982,134.07 | 803,042.64 | (800,000.00) | 9,985,176.71 |
| 9,985,176.71 | 803,287.42 | (800,000.00) | 9,988,464.13 |
| 9,988,464.13 | 803,551.89 | (800,000.00) | 9,992,016.02 |
| 9,992,016.02 | 803,837.63 | (800,000.00) | 9,995,853.64 |
| 9,995,853.64 | 804,146.36 | (10,800,000.00) | 0.00 |
| Total Amount Received: | 18,000,000.00 |
| Total Interest Recognized (via EIR): | 8,030,000.00 |
| Principal Portion Recovered: | 9,970,000.00 |
This matches our initial investment exactly!
Author's Note: Q: Wouldn't doing this affect the Statement of Profit or Loss (SOPL) and allow for profit manipulation?
A: Let's compare. Under traditional GAAP, you'd expense the 30,000 transaction cost upfront and recognize a 60,000 gain on expiry. The total income over the period would be (8,000,000 Interest + 60,000 Gain - 30,000 Cost) = 8,030,000. This is the exact same total income as recognized using the EIR method under IFRS/NFRS.
Author's Note: Q: If the total income is the same, why even bother with the complex EIR method? What value does it add?
A: The value lies in preventing manipulation of income timing. Let's see another example.
The CEO wants to boost profits during their tenure. They structure a deal to pay 10% interest for the first 4 years and 5% for the next 6 years. This front-loads the interest income.
Problem with Traditional GAAP
Under a simple cash-basis recognition, the interest income would be highly irregular (4M in the first four years, 3M in the next six), allowing the CEO to show inflated profits early on. This is manipulative and doesn't reflect the true economic substance of the deal.
IFRS/NFRS Solution: The EIR Method
IFRS/NFRS requires us to calculate a single effective interest rate over the entire life of the instrument, smoothing out the income recognition.
New Cash Flow Calculation:
| Year | Cash Flow |
|---|---|
| 0 | (9,970,000.00) |
| 1 | 1,000,000.00 |
| 2 | 1,000,000.00 |
| 3 | 1,000,000.00 |
| 4 | 1,000,000.00 |
| 5 | 500,000.00 |
| 6 | 500,000.00 |
| 7 | 500,000.00 |
| 8 | 500,000.00 |
| 9 | 500,000.00 |
| 10 | 10,500,000.00 |
New Effective Interest Rate (EIR) = 7.48%
New Amortization Schedule
| Opening | Interest @ EIR | Receipt | Closing |
|---|---|---|---|
| 9,970,000.00 | 745,997.50 | (1,000,000.00) | 9,715,997.50 |
| 9,715,997.50 | 726,991.96 | (1,000,000.00) | 9,442,989.46 |
| 9,442,989.46 | 706,564.35 | (1,000,000.00) | 9,149,553.81 |
| 9,149,553.81 | 684,608.25 | (1,000,000.00) | 8,834,162.06 |
| 8,834,162.06 | 661,009.31 | (500,000.00) | 8,995,171.37 |
| 8,995,171.37 | 673,056.71 | (500,000.00) | 9,168,228.07 |
| 9,168,228.07 | 686,005.54 | (500,000.00) | 9,354,233.61 |
| 9,354,233.61 | 699,923.26 | (500,000.00) | 9,554,156.87 |
| 9,554,156.87 | 714,882.36 | (500,000.00) | 9,769,039.23 |
| 9,769,039.23 | 730,960.77 | (10,500,000.00) | - |
Conclusion: Now, the interest income recognized each year is much more consistent, reflecting the true economic return. The incentive for the CEO to manipulate the contract terms is removed, leading to better and more consistent financial presentation.
FA at FVTOCI are initially recognized at total amount including the transaction cost (Same as in Amortized Cost). This method mirrors the Amortized Cost method with any FV changes transferred to a separate fair Value Reserve, that is eventually on derecognition reclassified to SOPL.
An entity purchases 1000 6-year debentures at 992 each, with transaction costs of Rs. 2 per debenture. The debentures have a coupon rate of 9%.
| Initial Outflow | 994,000.00 |
Schedule of Estimated Cash Flows
| Year | Cash Flow | PVF @ EIR | Present Value |
|---|---|---|---|
| 0 | (994,000.00) | - | - |
| 1 | 90,000.00 | 0.92 | 82,467.21 |
| 2 | 90,000.00 | 0.84 | 75,564.89 |
| 3 | 90,000.00 | 0.77 | 69,240.29 |
| 4 | 90,000.00 | 0.70 | 63,445.03 |
| 5 | 90,000.00 | 0.65 | 58,134.83 |
| 6 | 1,090,000.00 | 0.59 | 645,147.75 |
| Total Present Value | 994,000.00 | ||
EIR (using IRR function) = 9.13%
Amortization Schedule
| Year | Opening | Interest Costs | Receipts | Closing | FV of Debenture | Recognized in OCI |
|---|---|---|---|---|---|---|
| 1 | 994,000.00 | 90,794.82 | (90,000.00) | 994,794.82 | 997,000.00 | 2,205.18 |
| 2 | 994,794.82 | 90,867.42 | (90,000.00) | 995,662.24 | 997,500.00 | 1,837.76 |
| 3 | 995,662.24 | 90,946.66 | (90,000.00) | 996,608.90 | 997,250.00 | 641.10 |
| 4 | 996,608.90 | 91,033.13 | (90,000.00) | 997,642.02 | 994,300.00 | (3,342.02) |
| 5 | 997,642.02 | 91,127.49 | (90,000.00) | 998,769.52 | 998,700.00 | (69.52) |
| 6 | 998,769.52 | 91,230.48 | (1,090,000.00) | - | - | - |
| Total recognized in OCI | 1,272.50 | |||||
Journal Entries for each year: The interest cost is recognized in P&L, and the difference between the closing amortized cost and the fair value is recognized in OCI.
On Derecognition
The cumulative FV changes recognized in OCI are reclassified to SOPL as:
OCI - Reserve A/c Dr. 1,272.50
To SOPL A/c 1,272.50A company takes a loan from Hamaal Bank. The processing charges are deducted from the principal amount upfront. The company must calculate the Effective Interest Rate (EIR) to correctly account for the interest expense over the life of the loan.
Loan Details
| Loan from Hamaal Bank | 120,000,000 |
| Processing Charges | (1,800,000) |
| Net Proceeds (Initial Carrying Amount) | 118,200,000 |
| Interest Rate (Coupon) | 10% per annum |
| Term | 5 equal annual instalments |
Author's Note: Initial Recognition: The financial liability is initially recognized at its fair value, which is the net proceeds received. The transaction costs (processing charges) are not expensed immediately but are factored into the calculation of the EIR.
Total Cash Outflow Calculation
| Year | Loan (Beginning) | Repayment | Interest (10%) | Total Outflow |
|---|---|---|---|---|
| 1 | 120,000,000 | 24,000,000 | 12,000,000 | 36,000,000 |
| 2 | 96,000,000 | 24,000,000 | 9,600,000 | 33,600,000 |
| 3 | 72,000,000 | 24,000,000 | 7,200,000 | 31,200,000 |
| 4 | 48,000,000 | 24,000,000 | 4,800,000 | 28,800,000 |
| 5 | 24,000,000 | 24,000,000 | 2,400,000 | 26,400,000 |
EIR Calculation (Interpolation)
To find the EIR, we need to find the rate that makes the Present Value (PV) of all cash outflows equal to the net proceeds. We can do this by testing two rates (e.g., 9% and 11%) and interpolating.
| Year | Cash Flow | PVF @ 9% | PV @ 9% | PVF @ 11% | PV @ 11% |
|---|---|---|---|---|---|
| 1 | 36,000,000 | 0.917 | 33,027,523 | 0.901 | 32,432,432 |
| 2 | 33,600,000 | 0.842 | 28,280,448 | 0.812 | 27,270,514 |
| 3 | 31,200,000 | 0.772 | 24,092,125 | 0.731 | 22,813,171 |
| 4 | 28,800,000 | 0.708 | 20,402,646 | 0.659 | 18,971,452 |
| 5 | 26,400,000 | 0.650 | 17,158,189 | 0.593 | 15,667,115 |
| Total PV | 122,960,930 | 117,154,684 | |||
| Less: Net Proceeds | (118,200,000) | (118,200,000) | |||
| Net Present Value (NPV) | 4,760,930 | (1,045,316) | |||
Using the interpolation formula:
EIR = LRR + (NPV at LRR / (NPV at LRR - NPV at HRR)) * (HRR - LRR)
Effective Interest Rate (EIR) = 10.64%
Bank A/c Dr. 118,200,000
To Financial Liability (Loan) A/c 118,200,000
(To record loan at net proceeds received)What is Irrevocable Designation?
Under IFRS/NFRS 9, an entity may, at the time of initial recognition, make an irrevocable election to classify certain financial instruments such as equity instruments that do not qualify for classification at amortized cost or FVTPL — to be measured at Fair Value Through Other Comprehensive Income and vice versa.
Equity Instruments Irrevocably Designated as FV Through OCI
Nikhil and Upreti Restaurant, a Restaurant inside Dharahara Tower has made investments in Hamaal Commercial Bank. 100 Shares at 547 per Share.
The company is mainly a restaurant company but invests its spare funds in the shares of commercial banks as a relatively safe investment. Such Investments are not held for trading. Although the users will appreciate the effect of changes of FV in the Net worth, showing the changes in SOPL may shift the focus from the main restaurant operation and wont show a clear picture of the Operations. Therefore, the restaurant has decided to designate the Shares of Hamaal Commercial Banks as FVTOCI even though the shares are to be classified as FVTPL since they don’t meet the SPPI Criteria.
Important:
Where such an asset is classified at FVTOCI, the cumulative Fair Value gain is therefore not transferred to SOPL on derecognition. It can however be transferred to any heading within equity.
Cumulative FV Gain Reserve A/c Dr. XXXXX
To Retained Earnings A/c XXXXXImportant Considerations:
A Financial Asset may be reclassified only upon change of Business model. Mere intention of management cannot be used as basis for reclassification. All reclassification shall be accounted for prospectively .ie. no restatement of Financials is required for the prior period.
[ref: para 5.6.1] If an entity reclassifies financial assets in accordance with paragraph 4.4.1, it shall apply the reclassification prospectively from the reclassification date. The entity shall not restate any previously recognized gains, losses (including impairment gains or losses) or interest.
| Current Classification | Reclassification | Effect |
|---|---|---|
| Amortized Cost | FVTPL | The asset is remeasured at fair value on the reclassification date. The difference between the carrying amount and fair value is recognized in Profit or Loss. |
| FVTPL | Amortized Cost | The FV changes up to the date of reclassification are recognized in SOPL. Then, the FV on that date becomes the gross carrying amount for EIR Calculation. (For our Example, the FV on date becomes the initial outflow at Y0 End). |
| Amortized Cost | FVTOCI | The asset is remeasured at fair value, and the difference between amortized cost and fair value is recognized in OCI. The original EIR-based amortization schedule is not adjusted. |
| FVTOCI | Amortized Cost | The cumulative FV is Adjusted with the Cost of the asset as on that date. If an asset is measured at FVTOCI (Amortized Cost = 55,000; FV = 65,000), the asset is valued at 65,000 and Cumulative Reserve at 10,000. Therefore, if that 10,000 is adjusted with the value of the asset, the asset is measured at Amortized Cost. |
| FVTPL | FVTOCI | The asset continues to be measured at fair value. The fair value on the reclassification date becomes the new carrying amount. Future fair value changes go to OCI, and a new EIR is applied. (Refer Example: FVTPL to Amortized Cost). |
| FVTOCI | FVTPL | The asset continues to be measured at fair value, but from the reclassification date, fair value changes are now recognized in P&L. The cumulative gain/loss previously in OCI is reclassified to P&L. |
Berozgaar Trading Pvt. Ltd. held one loan portfolio (classified as FVTPL as it was held for trading) and other equity shares. On 31st March 2025, the company sold all its shares and changed its business model to investment management. It now holds the loan portfolio to obtain contractual cash flows, not for trading. The portfolio had a Fair Value of 5,500,000 on this date.
Reclassification Entry
First, reclassify the asset at its fair value on the date of change.
Loan Portfolio - Amortized Cost A/c Dr. 5,500,000.00
To Loan Portfolio - FVTPL A/c 5,500,000.00EIR and Amortization Calculation
Now, calculate the new EIR and amortization schedule based on the new 'Amortized Cost' carrying amount and estimated future cash flows.
Estimated Cash Flows
| Year | Cash Flow |
|---|---|
| 1 | 1,500,000 |
| 2 | 1,489,000 |
| 3 | 1,348,000 |
| 4 | 1,150,000 |
| 5 | 1,054,000 |
| 6 | 456,000 |
| 7 | 65,000 |
| Total | 7,062,000 |
EIR Calculation
| Year | Cash Flow | PVF @ 8.84% | PV |
|---|---|---|---|
| 0 | (5,500,000) | - | - |
| 1 | 1,500,000 | 0.92 | 1,378,133 |
| 2 | 1,489,000 | 0.84 | 1,256,882 |
| 3 | 1,348,000 | 0.78 | 1,045,417 |
| 4 | 1,150,000 | 0.71 | 819,403 |
| 5 | 1,054,000 | 0.65 | 689,986 |
| 6 | 456,000 | 0.60 | 274,261 |
| 7 | 65,000 | 0.55 | 35,918 |
Effective Interest Rate (EIR) = 8.84%
Amortization Schedule
| Year | Opening | Interest | Receipt | Closing |
|---|---|---|---|---|
| 1 | 5,500,000 | 486,359 | (1,500,000) | 4,486,359 |
| 2 | 4,486,359 | 396,724 | (1,489,000) | 3,394,084 |
| 3 | 3,394,084 | 300,135 | (1,348,000) | 2,346,219 |
| 4 | 2,346,219 | 207,474 | (1,150,000) | 1,403,693 |
| 5 | 1,403,693 | 124,127 | (1,054,000) | 473,820 |
| 6 | 473,820 | 41,899 | (456,000) | 59,719 |
| 7 | 59,719 | 5,281 | (65,000) | 0 |
This ledger shows the balances for the "Loan Portfolio - FA at Amortized Cost" account after reclassification.
| Debit | Credit | ||||
|---|---|---|---|---|---|
| Year | Particulars | Amount | Year | Particulars | Amount |
| 1 | To FA at FVTPL | 5,500,000 | 1 | By Bank A/c | 1,500,000 |
| To interest A/c | 486,359 | By Balance c/d | 4,486,359 | ||
| 2 | To balance c/d | 4,486,359 | 2 | By Bank A/c | 1,489,000 |
| To interest A/c | 396,724 | By Balance c/d | 3,394,084 | ||
| 3 | To FA at FVTPL | 3,394,084 | 3 | By Bank A/c | 1,348,000 |
| To interest A/c | 300,135 | By Balance c/d | 2,346,219 | ||
| 4 | To FA at FVTPL | 2,346,219 | 4 | By Bank A/c | 1,150,000 |
| To interest A/c | 207,474 | By Balance c/d | 1,403,693 | ||
| 5 | To FA at FVTPL | 1,403,693 | 5 | By Bank A/c | 1,054,000 |
| To interest A/c | 124,127 | By Balance c/d | 473,820 | ||
| 6 | To FA at FVTPL | 473,820 | 6 | By Bank A/c | 456,000 |
| To interest A/c | 41,899 | By Balance c/d | 59,719 | ||
| 7 | To FA at FVTPL | 59,719 | 7 | By Bank A/c | 65,000 |
| To interest A/c | 5,281 | By Balance c/d | (0) | ||
Compound financial instruments are instruments that, from the issuer’s perspective, contain both:
- A financial liability component (e.g. Interest Obligation and Principal Payment), and
- An equity component (e.g., an option granting the holder the right to convert the instrument into the issuer’s own equity).
Bishaal Lange Store Ltd issued 9% convertible debentures Rs 1,000,000 on 04/01/2025. These are to be converted into 5,000 equity shares of Rs 100 each (@120 per share) on 31/03/2030. Debentures were issued at a discount of 5%. Rate of interest for similar debentures without conversion feature is 14%.
The entity doesn't have an obligation to pay cash for the whole amount of Debenture. Instead the debentures are to be converted into Equity. The entity’s obligation is measured at it’s present value and classified as Liability Component, Whereas the remaining part is classified as equity.
Liability & Equity Component Calculation
| Year | Outflow | PVF @ 14% | Present Value |
|---|---|---|---|
| 1 | 90,000 | 0.88 | 78,947.37 |
| 2 | 90,000 | 0.77 | 69,252.08 |
| 3 | 90,000 | 0.67 | 60,747.44 |
| 4 | 90,000 | 0.59 | 53,287.22 |
| 5 | 90,000 | 0.52 | 46,743.18 |
| Financial Liability at Amortized Cost | 308,977.29 | ||
| Net Proceeds | 950,000.00 | ||
| Equity Portion (bal. fig.) | 641,022.71 | ||
Author's Note: Since the debentures are mandatorily convertible into equity shares at maturity, the entity has no contractual obligation to repay the principal in cash, the instrument is a compound financial instrument.
Amortization Schedule
| Year | Opening | Interest | Payment | Closing | Equity |
|---|---|---|---|---|---|
| 1 | 308,977.29 | 43,256.82 | 90,000.00 | 262,234.11 | ****** |
| 2 | 262,234.11 | 36,712.78 | 90,000.00 | 208,946.88 | ****** |
| 3 | 208,946.88 | 29,252.56 | 90,000.00 | 148,199.45 | ****** |
| 4 | 148,199.45 | 20,747.92 | 90,000.00 | 78,947.37 | ****** |
| 5 | 78,947.37 | 11,052.63 | 90,000.00 | 0.00 | (Equity is never remeasured) |
On Conversion
Equity A/c Dr. 641,022.71
To Equity Share Capital A/c 500,000.00
To Share Premium A/c 100,000.00
To Other components of Equity A/c 41,022.71Author's Note on 'Other components of Equity': This is the Standard's way of saying "just put it anywhere inside equity". Simply, transfer the amount to retained earnings.
Other Components of Equity A/c Dr. 41,022.71
To Retained Earnings A/c 41,022.71Bishaal Lange Store Ltd issued 9% convertible debentures Rs 1,000,000 on 04/01/2025. These may be converted into 5,000 equity shares of Rs 100 each (@120 per share) on 31/03/2030 **if the holders opt for the conversion**. Debentures were issued at a discount of 5%. Rate of interest for similar debentures without conversion feature is 14%.
Liability & Equity Component Calculation
| Year | Outflow | PVF @ 14% | Present Value |
|---|---|---|---|
| 1 | 90,000 | 0.88 | 78,947.37 |
| 2 | 90,000 | 0.77 | 69,252.08 |
| 3 | 90,000 | 0.67 | 60,747.44 |
| 4 | 90,000 | 0.59 | 53,287.22 |
| 5 | 1,090,000 | 0.52 | 566,111.84 |
| Financial Liability at Amortized Cost | 828,345.95 | ||
| Net Proceeds | 950,000.00 | ||
| Equity Component (bal. fig.) | 121,654.05 | ||
Author's Note: Now, why does the final payment contain the principal amount? Since the debentures are convertible into equity shares if opted by the holders, i.e. the conversion is in the hands of the holder, and therefore, the entity may have contractual obligation to repay the principal in cash, if the holders don’t opt for conversion.
Using the same details as Scenario 2, we now have the amortization schedule for the liability component.
Amortization Schedule
| Year | Opening | Interest | Payment | Closing |
|---|---|---|---|---|
| 1 | 828,345.95 | 115,968.43 | (90,000.00) | 854,314.38 |
| 2 | 854,314.38 | 119,604.01 | (90,000.00) | 883,918.40 |
| 3 | 883,918.40 | 123,748.58 | (90,000.00) | 917,666.97 |
| 4 | 917,666.97 | 128,473.38 | (90,000.00) | 956,140.35 |
| 5 | 956,140.35 | 133,859.65 | (90,000.00) | 1,000,000.00 |
Before conversion, the carrying amounts are: Equity Component: 121,654.05 and Financial Liability: 1,000,000.00
Assume that 50% of bondholders opt for cash payment and the remaining opt for shares.
Journal Entry on Settlement
| Equity A/c Dr. | 121,654.05 |
| Financial Liability A/c Dr. | 978,345.95 |
| To Equity Share Capital | 500,000.00 |
| To Share Premium A/c | 100,000.00 |
| To Cash | 500,000.00 |
Share Capital = 50% * 10,000 shares * Rs. 100 face value
Share Premium = 50% * 10,000 shares * Rs. 20 premium
A balance of 21,654.05 remains in the Financial Liability account. Since the entity has no future obligation, this represents a gain on the extinguishment of the liability.
Financial Liability A/c Dr. 21,654.05
To Gain on Extinguishment of Liability (SOPL) A/c 21,654.05On 1st April, 2025, Eva Giri's "Beautify" Company has taken a 10-year loan from Hamaal Bank amounting to 30,000,000 @ 9% coupon rate with an initial Service charge @ 0.25% of the Gross Loan.
| Gross Loan | 30,000,000.00 |
| Service Charge | (75,000.00) |
| Net Loan Received | 29,925,000.00 |
| Equal Annual Installment | 4,674,602.70 |
Initial Amortization Schedule (EIR = 9.06%)
| Year | Opening | Interest | Payment | Closing |
|---|---|---|---|---|
| 1 | 29,925,000.00 | 2,710,279.66 | 4,674,602.70 | 27,960,676.96 |
| 2 | 27,960,676.96 | 2,532,372.74 | 4,674,602.70 | 25,818,447.00 |
| 3 | 25,818,447.00 | 2,338,352.94 | 4,674,602.70 | 23,482,197.25 |
| 4 | 23,482,197.25 | 2,126,760.96 | 4,674,602.70 | 20,934,355.51 |
| 5 | 20,934,355.51 | 1,896,005.28 | 4,674,602.70 | 18,155,758.09 |
| 6 | 18,155,758.09 | 1,644,350.27 | 4,674,602.70 | 15,125,505.66 |
| 7 | 15,125,505.66 | 1,369,903.10 | 4,674,602.70 | 11,820,806.07 |
| 8 | 11,820,806.07 | 1,070,599.51 | 4,674,602.70 | 8,216,802.88 |
| 9 | 8,216,802.88 | 744,188.26 | 4,674,602.70 | 4,286,388.45 |
| 10 | 4,286,388.45 | 388,214.25 | 4,674,602.70 | 0.00 |
Scenario 1: Expected Change (Base Rate)
Assuming at the end of Y-5, the Bank changed the interest rate to 10.45% on account of a change of base rate. As a result, the annual equal installment became 4,851,764.48.
Since this change is due to a variable base rate, it's considered an **expected change**. The entity calculates a new EIR and continues amortization without recognizing any gain or loss.
New EIR Calculation (from Y-5 onwards)
| Year | Cash Flows | PVF @ EIR | Present Value |
|---|---|---|---|
| 0 | (18,155,758.09) | - | Closing balance at the end of Y-5 |
| 1 | 4,851,764.48 | 0.90 | 4,390,416.95 |
| 2 | 4,851,764.48 | 0.82 | 3,972,938.32 |
| 3 | 4,851,764.48 | 0.74 | 3,595,157.14 |
| 4 | 4,851,764.48 | 0.67 | 3,253,298.66 |
| 5 | 4,851,764.48 | 0.61 | 2,943,947.02 |
| IRR (New EIR) | 10.51% | ||
Scenario 2: Unexpected Change (Negotiated Rate)
Assuming at the end of Y-5, with discussion with the Bank, the company managed to reduce the interest rate to 8% p.a. The new annual equal installment is 4,553,926.00.
Author's Note: Should we now remeasure the EIR to account for the changes? First, let's identify why we remeasured EIR in the first place. A bank's interest rate is based on two components:
- Base Rate: Variable and expected to change during the life of the loan.
- Premium: A compensatory portion based on the customer's risk profile, ordinarily expected to remain fixed.
In the first example, the rate changed due to the base rate, which is an expected phenomenon. Therefore, no gain or loss arises. However, a change in the premium is different and not anticipated. If the liability increases, a loss is booked, and if it decreases, a gain is booked.
General Rule:
- Expected to Change: No gain/loss, Calculate new EIR.
- Not ordinarily Expected to Change: Calculate Gain/Loss and EIR remains Same.
Gain on Modification Calculation
| Year | Cash Flows | PVF @ 9.06% | Present Value |
|---|---|---|---|
| 1 | 4,553,926.00 | 0.92 | 4,175,733.65 |
| 2 | 4,553,926.00 | 0.84 | 3,828,949.25 |
| 3 | 4,553,926.00 | 0.77 | 3,510,964.44 |
| 4 | 4,553,926.00 | 0.71 | 3,219,387.48 |
| 5 | 4,553,926.00 | 0.65 | 2,952,025.27 |
| New Amortized Cost of Revised Cash Flows @ 9.06% | 17,687,060.09 | ||
| Current Amortized cost @ Calculated EIR of 9.06% | 18,155,758.09 |
| New Amortized Cost of Revised Cash Flows @ 9.06% | (17,687,060.09) |
| Gain on Modification | 468,698.00 |
Financial Liability A/c Dr. 468,698.00
To Gain on Modification A/c (SOPL) 468,698.00New Amortized Schedule (using same original EIR)
| Opening | Interest @ 9.06% | Payment | Closing |
|---|---|---|---|
| 17,687,060.09 | 1,601,900.73 | 4,553,926.00 | 14,735,034.82 |
| 14,735,034.82 | 1,334,538.52 | 4,553,926.00 | 11,515,647.34 |
| 11,515,647.34 | 1,042,961.56 | 4,553,926.00 | 8,004,682.90 |
| 8,004,682.90 | 724,976.75 | 4,553,926.00 | 4,175,733.65 |
| 4,175,733.65 | 378,192.35 | 4,553,926.00 | 0.00 |
| 17,687,060.09 | 5,082,569.91 | 22,769,630.00 | - |
No impairment loss is calculated for Financial Assets measured at Fair Value as the Fair Value already incorporates any and every loss event and its impacts on the Financial Asset.
| S.N. | Within Scope | Outside Scope |
|---|---|---|
| 1. | Financial Asset at Amortized Cost | Financial Assets at FV Through PL |
| 2. | Financial Assets at FV Through OCI | Equity Shares Irrevocably designated at FVTOCI |
Approaches to Impairment:
- Simplified Approach for Trade & Lease Receivables.
- General Approach for Other Financial Assets.
Trade Receivables and Lease Receivables are non-complex financial Instruments, whose recognition criteria is generally easy and straightforward without any calculations as is required for Other Financial Assets (Like a Loan Portfolio).
Therefore, a simplified Expected Credit loss matric may be used. Companies need to estimate how much money they might lose from unpaid customer debts (trade receivables). This estimate, called Expected Credit Losses (ECLs), should be fair, based on probabilities, and use all relevant information available without too much cost or effort.
This includes looking at:
- What happened in the past: Historical payment trends.
- What's happening now: Current economic conditions.
- What might happen next: Future economic forecasts.
For short-term debts, many companies might not typically bother changing their ECL estimates based on future economic changes, as past trends are usually a good guide.
However, sometimes things like economic downturns or global uncertainties can suddenly and drastically change how quickly customers pay their bills. In such cases, companies must re-evaluate how these external events will affect future economic conditions and consider a longer period for their estimates, especially if payment dates are being delayed significantly.
Using a "Provision Matrix" (Simplified Method)
IFRS 9 allows companies to use simpler ways to calculate ECLs, like a "provision matrix." This is basically a table that helps estimate losses based on how old the debt is.
This Is just an example. Please do not use for actual Scenarios
Using Central Bank’s Provision as a base Line.
| Pass Loans | 1% | upto 30 Days |
| Watchlist Loans | 5% | upto 3 Months |
| Substandard Loas | 25% | upto 6 Months |
| Doubtful Loans | 50% | Upto 12 Months |
| Loss Loans | 100% | After 12 Months |
The respective rates are then multiplied with an adjusting factor.
Where adjusting factor = Original Rate / k * Original Rate^p
Where, k is a scaling factor and p is a power to control adjustment intensity.
K is calculated as: The Total Asset of Largest Commercial Bank for which the bank’s Provision Apply / Total Asset of The concerned Entity. Let’s just Assume, the value is 10.
P (Adjustment Intensity) is calculated as: Total Asset of the Concerned Entity / Total Asset of Lowest class of Financial Institutions for which the Provisions Applies. Let’s Assume that as 0.08
The Adjusted rate come as:
| Classification | Allowance Rate |
|---|---|
| Prime Receivables | 0.05% |
| Standard Receivables | 0.26% |
| Watchlist receivables | 1.49% |
| Concern receivables | 3.15% |
| Doubtful receivables | 6.67% |
Write off Any receivables that have been concluded as being Non-Receivables.
| Current | Prime Receivables | Standard Receivables | Watchlist receivables | Concern receivables | Doubtful receivables |
|---|---|---|---|---|---|
| Allowance rate | 0.05% | 0.26% | 1.49% | 3.15% | 6.67% |
| Portfolio of Receivables | 22,500,000.00 | 14,500,000.00 | 2,500,000.00 | 3,500,000.00 | 7,000,000.00 |
| Allowance Amount | 10,273.47 | 37,784.96 | 37,179.82 | 110,206.20 | 466,666.67 |
Again, This is just an Example, Please don’t try to use it.
The general model of impairment applies to financial assets other than trade receivables and lease receivables, and is based on the Expected Credit Loss (ECL) model introduced by NFRS 39, replacing the earlier incurred loss model as per NAS 39.
Under the previous incurred loss approach, impairment was recognized only when a loss event had actually occurred. In contrast, the ECL model takes a forward-looking approach, requiring entities to estimate potential credit losses even if no loss event has yet happened. It emphasizes assessing whether a credit loss may occur under current and forecasted conditions, and recognizing the financial impact of such a possibility.
Thus, the ECL model focuses on estimating future losses using a combination of:
- Historical data,
- Current credit conditions, and
- Reasonable forecasts of future economic scenarios.
This ensures that credit losses are recognized earlier and more accurately, improving the timeliness and transparency of financial reporting.
Stages of Impairment:
The ECL method of Impairment consists of classifying the financial Assets into three Stages:
The Assets in which credit risk has not increased Significantly since inception. (E.g., New Loan Portfolio, Assets where receipts are regular and there is no indication that credit risk has increased.)
The Assets in Which credit risk has increased significantly. (E.g., Loan portfolio of Gold Traders when the gold has lost its value or market conditions indicate such possibility)
The Assets which have been impaired at the reporting date. (E.g., There has been a default of payment by the Gold Traders on their Loans)
This Method of Calculation of Impairment is majorly relevant as well as complex for Banks and Financial Institution as they hold large portfolio of Loans and other Financial Assets Measured at Amortized cost.
Note: NFRS 9 Doesn’t Prescribe any techniques or formulas to calculate the impairment of Financial Assets but provides general guidelines as described above.
General Practice is to use the three part formula:
EAD x LGD x PD
= Exposure at Default x Loss Given Default x Probability of Default.
Exposure at Default:
This is the carrying amount of the financial Asset at the point of default. If we are expecting the asset will default at the reporting date – even though the risk is low i.e. Stage 1, which we do at the period end for calculation of impairment Losses/Gains.
Loss Given Default:
This is the amount that will be lost given the default happens. E.g. The Total Loan Portfolio consists of 50 Loans at amortized cost of 58,000,000.00. Among the Loans, 75% have been mortgaged through land and the value of Land is enough to cover the financial Asset then, the Loss given Default would be the 25% = 14,500,000.00.
| S.N. | Loans From | Amortized Cost | FV of Mortgaged Asset | Further Insurance Coverage | Total Cover | Loss Given Default |
|---|---|---|---|---|---|---|
| 1 | Arjun Sharma | 5,225,000.00 | 3,396,250.00 | 261,250.00 | 3,657,500.00 | 1,567,500.00 |
| 2 | Meera Joshi | 9,856,000.00 | 8,574,720.00 | 492,800.00 | 9,067,520.00 | 788,480.00 |
| 3 | Ravi Thapa | 2,356,800.00 | 2,097,552.00 | 117,840.00 | 2,215,392.00 | 141,408.00 |
| 4 | Sneha Koirala | 4,589,000.00 | 2,478,060.00 | 229,450.00 | 2,707,510.00 | 1,881,490.00 |
| 5 | Aayush Bhandari | 6,589,000.00 | 5,139,420.00 | 329,450.00 | 5,468,870.00 | 1,120,130.00 |
| 6 | Nisha Adhikari | 4,578,000.00 | 4,074,420.00 | 228,900.00 | 4,303,320.00 | 274,680.00 |
| 7 | Pratik Shrestha | 2,549,000.00 | 2,345,080.00 | 127,450.00 | 2,472,530.00 | 76,470.00 |
| 8 | Anjali Gurung | 3,258,000.00 | 2,541,240.00 | 162,900.00 | 2,704,140.00 | 553,860.00 |
| 9 | Sagar Khadka | 5,641,000.00 | 5,528,180.00 | 282,050.00 | 5,810,230.00 | 0 {Cannot be Negative} |
| 10 | Pooja Tamang | 6,492,000.00 | 6,621,840.00 | 324,600.00 | 6,946,440.00 | 0 {Cannot be Negative} |
| Total | 51,133,800.00 | 42,796,762.00 | 2,556,690.00 | 45,353,452.00 | 6,404,018.00 | |
Probability of Default:
As the name suggests, it is the probability that default will occur. This is the major headache for major banks and financial institutions to calculate. As NFRS 9 doesn’t provide any data as to the calculation of Probability of Default, most institutions use a statistical approach.
Sample Example: Assume the Same loan Portfolio of Gold Traders. The Quaterly Data for the gold portfolio for 3 years is as below (ignore payment and Interest)
| Year | Loan Classification | Classification (Amount) | Classification (%) | ||||||
|---|---|---|---|---|---|---|---|---|---|
| Good Loans | Sub-Standard | Risky Loans | Loss Loans | Good | Sub-Standard | Risky | Loss | ||
| 1 | Quarter 1 | 250,000,000.00 | - | - | - | 25% | - | - | - |
| 1 | Quarter 2 | 187,500,000.00 | 62,500,000.00 | - | - | 34% | 25% | - | - |
| 1 | Quarter 3 | 171,250,000.00 | 63,125,000.00 | 15,625,000.00 | - | 37% | 25% | 31% | - |
| 1 | Quarter 4 | 165,462,500.00 | 63,756,250.00 | 15,937,500.00 | 4,843,750.00 | 39% | 25% | 31% | 100% |
| 2 | Quarter 1 | 164,360,875.00 | 64,393,812.50 | 16,256,250.00 | 4,989,062.50 | 40% | 26% | 32% | 100% |
| 2 | Quarter 2 | 163,242,140.00 | 65,037,750.63 | 16,581,375.00 | 5,138,734.38 | 40% | 26% | 33% | 100% |
| 2 | Quarter 3 | 161,900,423.59 | 65,688,128.13 | 16,913,002.50 | 5,498,445.78 | 41% | 26% | 33% | 100% |
| 2 | Quarter 4 | 160,740,328.88 | 66,345,009.41 | 17,251,262.55 | 5,663,399.15 | 42% | 27% | 34% | 100% |
| 3 | Quarter 1 | 159,561,951.56 | 67,008,459.51 | 17,596,287.80 | 5,833,301.13 | 42% | 27% | 36% | 100% |
| 3 | Quarter 2 | 158,014,944.11 | 67,678,544.10 | 17,948,213.56 | 6,358,298.23 | 43% | 27% | 36% | 100% |
| 3 | Quarter 3 | 156,788,445.45 | 68,355,329.54 | 18,307,177.83 | 6,549,047.18 | 44% | 27% | 39% | 100% |
| 3 | Quarter 4 | 155,083,843.88 | 69,038,882.84 | 18,673,321.38 | 7,203,951.90 | - | - | - | - |
| Average | 39% | 26% | 34% | 100% | |||||
Explanation: What % of one class of loans quarterly change into a higher risk category. i.e. On Average 39% of Good loans eventually end up as Substandard, 26% substandard eventually become risky and so on. The total Probability of Good Loans turning into loss loans = 39% * 26% * 34% * 100% = 3.45% and so on.
| Good Loans | Sub-Standard | Risky | Loss | Total | |
|---|---|---|---|---|---|
| Probability of Default | 3.45% | 8.90% | 34.04% | 100.00% | - |
| Exposure at Default | 155,083,843.88 | 69,038,882.84 | 18,673,321.38 | 7,203,951.90 | - |
| Loss Given Default (Assuming 75% is insured and no mortgage) | 25% | 25% | 25% | 25% | - |
| Impairment Loss to be Recognized | 1,339,305.12 | 1,535,940.22 | 1,589,035.68 | 1,800,987.97 | 6,265,268.99 |
Rajesh Hamaal and Productions Pvt. Ltd. provided a loan to Nikhil Upreti Association amounting 50,000,000.00 @ 15% p.a. charged service fees at 0.25% for 5 Years.
Financial Asset at Amortized Cost
| Initial Recognition: | 49,875,000.00 |
| Installments: | 14,915,777.62 |
Calculation of IRR
| Year | Cash Flows | Pvf @ EIR | Present Value |
|---|---|---|---|
| 0 | (49,875,000.00) | - | - |
| 1 | 14,915,777.62 | 0.87 | 12,958,319.20 |
| 2 | 14,915,777.62 | 0.75 | 11,257,746.05 |
| 3 | 14,915,777.62 | 0.66 | 9,780,346.05 |
| 4 | 14,915,777.62 | 0.57 | 8,496,831.29 |
| 5 | 14,915,777.62 | 0.49 | 7,381,757.41 |
| EIR: 15.11% | 49,875,000.00 | ||
At the end of 1st Year Closing balance: 42,493,242.59
After the first Year, Nikhil Upreti is in a Serious financial situation and therefore, it is unlikely that it will be able to make full payment.
Rajesh and Hamaal Production has estimated the future inflows as follows:
| Year | Cash Inflow | PVF @ EIR | Present Value |
|---|---|---|---|
| 1 | 11,186,800.00 | 0.87 | 9,718,710.54 |
| 2 | 10,441,000.00 | 0.75 | 7,880,388.77 |
| 3 | 9,695,300.00 | 0.66 | 6,357,254.14 |
| 4 | 8,203,700.00 | 0.57 | 4,673,269.92 |
| New Amortized Cost | 28,629,623.37 |
| Old Amortized Cost | 42,493,242.59 |
| Impairment Loss: | 13,863,619.22 |
Therefore, Impairment is the difference of amortized cost of Original Contractual cash Flows discounted at EIR and Estimated Future Cash flows discounted at the same EIR.
| Stage | Interest Income Recognition |
|---|---|
| Stage 1 | Interest Income is Booked as per EIR Method i.e. Amortized Cost * EIR |
| Stage 2 | Since default has still not happened, Book Interest income as Gross Amortized cost * EIR |
| Stage 3 | Default has occurred. The recognition of original interest income no longer makes sense. Therefore, Interest Income = Net Amortized Cost * EIR |
• Gross Amortized Cost = PV of Inflows (Closing amount of Asset w/o Reducing the impairment Loss recognized in relation to the Asset)
• Net Amortized Cost = Gross Amortized Cost – Impairment loss recognized for the particular asset.
Example:
In the previous example where, Nikhil took loan from Rajesh:
Gross Amortized Cost at the end of Y- 1 = 42,493,242.59
| Scenario | Stage of Financial Asset | Interest Income |
|---|---|---|
| 1 | Stage 1 | 42,493,242.59 * 15.11% |
| 2 | Stage 2 | 42,493,242.59 * 15.11% |
| 3 | Stage 3 | 28,629,623.37 * 15.11% |
Derecognition of Financial Assets
A financial asset is derecognized when:
- The contractual rights to the cash flows from the financial asset expire, or
- The entity transfers the financial asset and substantially all the risks and rewards of ownership.
There are two ways of derecognition:
- Derecognition of a significant Part of the Financial Assets
(This can be applied only if:
- The part comprises only specifically identified cash flows. E.g. Selling the interest portion or just the principal Portion of a Debenture Asset.
- The part comprises only a fully proportionate (pro rata) share of the cash flows. E.g. 60% of all Cash Flows (including interest and Principal).
- The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows. E.g. 60% of Interest Cash Flows.
)
That means these do not Qualify for Derecognition as a part of a Financial Assets.
- Sale of first 500,000.00 from the inflows of the Financial Assets: This is not a proportionate or specifically identified part as per IFRS 9.
- Sale of 60% of Interest and if any principal is received upto 60% of the principal: This is not a clean proportionate share of all or specifically identified cash flows. It’s a hybrid, and thus fails to qualify.
Suppose Rajesh and Hamaal sells the whole asset to Nima Prakash Pvt. Ltd. for 41,000,000 then, that constitutes a full derecognition.
| Amortized Cost: | 42,493,242.59 |
| Sale Proceeds | (41,000,000.00) |
| Loss on Sale | 1,493,242.59 |
Journal Entry:
Bank A/c Dr. 41,000,000.00
Loss on Sale A/c Dr. 1,493,242.59
To Loan Asset (Amortized Cost) A/c 42,493,242.59Rajesh and Hamaal enters into an agreement to sell the interest strip of the loan provided to Nikhil Association to Nima Prakash Pvt. Ltd. The loan's EIR is 15.11%.
Given Amortization Schedule:
| Opening | Interest | Interest Receipt | Principal Receipt | Closing |
|---|---|---|---|---|
| 49,875,000.00 | 7,534,020.21 | (7,534,020.21) | (7,381,757.41) | 42,493,242.59 |
| 42,493,242.59 | 6,418,946.33 | (6,418,946.33) | (8,496,831.29) | 33,996,411.30 |
| 33,996,411.30 | 5,135,431.57 | (5,135,431.57) | (9,780,346.05) | 24,216,065.25 |
| 24,216,065.25 | 3,658,031.58 | (3,658,031.58) | (11,257,746.05) | 12,958,319.20 |
| 12,958,319.20 | 1,957,458.42 | (1,957,458.42) | (12,958,319.20) | - |
| 49,875,000.00 | 24,703,888.12 | (24,703,888.12) | (49,875,000.00) | - |
Calculation at End of Year 1
| Amortized Cost | 42,493,242.59 |
| Remaining Interest | 17,169,867.91 |
Calculation PV of Remaining Interest:
| Interest Receipts | PVF @ EIR | Present Value |
|---|---|---|
| 6,418,946.33 | 0.87 | 5,576,561.79 |
| 5,135,431.57 | 0.75 | 3,875,988.63 |
| 3,658,031.58 | 0.66 | 2,398,588.64 |
| 1,957,458.42 | 0.57 | 1,115,073.88 |
| PV of Interest Strip | 12,966,212.93 | |
| Sale proceeds | 13,500,000.00 | |
| Gain on Sale of Interest Strip | 533,787.07 | |
Journal Entry:
Bank A/c Dr. 13,500,000.00
To Gain on Sale A/c 533,787.07
To Financial Asset - Interest Portion 12,966,212.93