Transcript of Ind AS 109 Financial Instruments | Concept and Interview Questions

welcome back to finance k your go-to channel for mastering Finance Concepts and acing interviews today we'll explore indd as 109 financial instruments a very important topic for interviews if you're preparing for interviews or just looking to sharpen your understanding of this standard you're in the right place before we start check out the description for links to our other videos on accounting standards and finance topics don't forget to subscribe share this video with your peers and watch it a couple of times to Sol ify your Concepts now let's discuss the objective of indas 109 financial instruments the primary aim of this standard is to establish a robust framework for recognizing measuring and disclosing financial instruments it's about ensuring that users of financial statements can understand the risks associated with these instruments and how they affect the financial position of an entity by providing clear principles I the as 109 enhances transparency and comparability helping stakeholders make informed decisions now what exactly is a financial instrument as per indas 109 a financial instrument is essentially any contract that gives rise to a financial asset for one entity and a financial liability or Equity instrument for another this includes a wide range of items such as cash loans receivables and investments in shares understanding these definitions is crucial as they form the foundation for how we recognize and measure Financial assets liabilities and equity instruments under this standard now let's discuss the scope of indas 109 and its exclusions indas 109 primarily applies to financial instruments but it's important to note that certain types of instruments are excluded from its scope for instance employe benefits and leases fall outside of the standard this means that while indd as 109 Prov provides a comprehensive framework for financial instruments it doesn't cover every Financial Arrangement which is crucial for companies to understand in their reporting processes now let's delve into how Financial assets are classified under indd as19 there are three main classifications amorti cost fair value through profit or loss fvtpl and fair value through other comprehensive income FCI each classification has specific criteria that determine how fin fincial assets are measured and reported understanding these classifications is vital for accurate financial reporting and ensuring compliance with the standard ultimately aiding in better decision- making for stakeholders next the distinctions between advertised cost fvtpl and fv1 in indas 109 financial instruments advertised cost is primarily used for financial assets held with the intention of collecting contractual cash flows like loans or bonds where the cash flows are fixed or determinable in contrast fvtpl or fair value through profit or loss applies to assets held for trading or those that don't meet the criteria for amortized cost or FCI think of it as stocks or derivatives where fluctuations in market value directly impact profit FCI or fair value through other comprehensive income is a middle ground suitable for assets where you want to capture fair value changes without affecting profit until realized like certain Equity Investments next let's explore the business model test and contractual cash flow characteristics test the business model test assesses how an entity manages its Financial assets whether to collect cash flows or sell the assets the contractual cash flow characteristics test examines whether the cash flows from the asset are solely payments of principal and interest together these tests guide the classification of financial assets ensuring they align with the entity's strategy and the nature of cash flows now let's discuss the classification of financial assets under indd as19 can their classification change after initial recognition yes but only under certain conditions specifically if there's a change in the entity's business model for managing Financial assets reclassification is permissible this means that if the purpose for which you hold an asset shifts perhaps from holding it for a collection to selling it then you can reclassify it however it's important to note that this is not a frequent occurrence and must be carefully documented now let's move on to the accounting treatment for financial liabilities under indas 109 initially Financial liabilities are recognized at fair value which generally means the transaction price for subsequent measurement they can be carried at amortised cost or fair value depending on the classification finally D recognition occurs when the obligation is settled cancelled or expires ensuring that your financial statements accurately reflect your liabilities now let's discuss the expected credit loss ecl model under indas 109 the ecl model shifts the Paradigm from a historical view of credit losses to a forward-looking approach this means that entities must assess the risk of default over the life of a financial instrument considering not just past events but also future economic conditions it emphasizes proactive risk management allowing organizations to recognize impairment earlier in the life cycle of their assets now let's explore how the ecl model differs from the incurred loss model the key change lies in the timing of loss recognition while the incurred loss model waits for a loss event to occur before recognizing impairment the ecl model requires entities to estimate expected losses even before any default happens this proactive stance offers practical advantages enabling better Financial forecasting and improved credit risk management ultimately leading to more resilient financial reporting now let's discuss the three stages of impairment under the ecl model in indd as9 financial instruments first we have the 12-month ecl stage which assesses the expected credit losses over the next year for financial instruments that have not shown significant credit deterioration then we move to the lifetime ecl stage where we evaluate instruments that have experienced a significant increase in credit risk since initial recognition this stage requires a more comprehensive analysis as we're looking at potential losses over the entire life of the asset finally we encounter the credit impaired stage where the asset is considered credit impaired indicating a significant default risk now how do we determine a significant increase in credit risk it's crucial to identify key indicators such as payment delinquencies or adverse changes in the borrower Financial condition practical examples include monitoring credit ratings or analyzing macroeconomic factors that may affect the borrower's ability to repay now let's discuss the treatment for credit impaired Financial assets under indas 109 first recognition is key you need to identify when an asset is credit impaired typically when there's a significant increase in credit credit risk measurement follows where you must assess the expected credit loss or ecl reflecting the assets risk profile disclosure requirements are equally important ensure you provide clear information about the methodologies used for ecl calculations and the assumptions underlying your estimates next let's tackle how to calculate Lifetime ecl and 12month ecl start with the key inputs probability of default PD which estimates the like Ood of a borrower defaulting loss given default lgd which assesses the potential loss if default occurs and exposure at default EAD representing the total value at risk for Lifetime ecl aggregate these inputs over the expected life of the asset while the 12-month ecl focuses on the first year of risk now let's discuss hedge accounting under indd as19 hedge accounting is all about aligning the financial report of an entity with its risk management activities it allows companies to mitigate the volatility in profit or loss that can arise from changes in the fair value of financial instruments by designating certain hedging relationships entities can ensure that their financial statements reflect the economic reality of their risk management strategies now let's explore the types of Hedges fair value hedge cash flow hedge and net investment hedge a fair value hedge is used to offset exposure to changes in the fair value of a recognized asset or liability like a fixed rate bond a cash flow hedge on the other hand protects against variability in cash flows such as future interest payments on a variable rate loan lastly a net investment hedge is used to hedge foreign currency risks in foreign operations each type has distinct journal entries reflecting their unique impacts on financial statements and risk management objectives now let's discuss the criteria for applying Hedge accounting under indas 109 the first step is documentation it's crucial to have a formal hedge documentation that outlines the risk management objective and strategy this documentation must clearly identify the hedging instrument the hedged item and the nature of the risk being hedged additionally Effectiveness requirements are Paramount the Hedge must be expected to be highly effective in offsetting changes in fair value or cash flows this means that both prospective and retrospective assessments of Effectiveness must be conducted to ensure compliance now let's move on to how hedge Effectiveness is assessed under indas 109 this involves both quantitative and qualitative testing quantitative testing typically uses statistical methods to measure the degree of offset between the hedging instrument and the hedged item while qualitative testing focuses on the economic relationship and the rationale behind the Hedge it's essential to document these assessments meticulously to maintain compliance and transparency now let's discuss how the fair value of financial instruments is determined the process hinges on the fair value hierarchy which categorizes inputs into three levels level one inputs are quoted prices in active markets for identical assets or liabilities offering the highest Rel reliability level two inputs are observable but not directly from the market such as prices for similar instruments finally level three inputs are unobservable relying on the entity's own assumptions and models often leading to Greater uncertainty understanding these levels is crucial for accurate financial reporting next let's explore the concept of day one profit or loss in Fair Value measurement this arises when an entity recognizes a financial instrument at fair value but the market price is not observable in such cases the initial recognition may lead to a day one profit or loss reflecting the difference between the transaction price and the fair value determined using level two or level three inputs this concept is vital for transparency in financial statements now let's delve into the concept of embedded derivatives under indas 109 an embedded derivative is a component of a hybrid Financial instrument that can lead to cash flows based on a variable to account for it first identify if the embedded feature meets the separation criteria it must be distinct from the host contract meaning it should not be closely related to the Main Financial instrument if it's separable then it's recognized as a separate derivative impacting how gains and losses are reported now let's explore the conditions under which a financial asset is derecognized under indd as19 the recognition occurs when the entity transfers the risks and rewards associated with the asset this means if the risks and Rewards are substantially transferred the asset is removed from the balance sheet understanding these criteria ensures accurate financial reporting and compliance with the standards which is crucial for stakeholders now let's dive into the difference between modification and recognition of financial liabilities modification refers to changes in the terms of a financial liability such as adjusting interest rates or extending payment terms which might occur during a restructuring for instance since if a company renegotiates its loan terms to lower interest rates this is a modification on the other hand the recognition occurs when a financial liability is extinguished like when a loan is paid off completely think of it as extinguishing a fire versus simply changing its shape one is about elimination the other about adjustment now let's discuss how to calculate gain or loss on the D recognition of financial assets. question mark question mark start by determining the carrying amount of the financial asset at the time of D recognition this involves looking at the original cost adjusted for any amortization or impairment next identify the proceeds from the D recognition which could be cash received or the fair value of any assets received in exchange the key step here is to subtract the carrying amount from the proceeds for example if the carrying amount of a bond is 1,000 then you sell it for 1,200 your gain is 200 conversely if you sell it for 800 you incur a loss of 200 finally ensure that you account for any transaction costs as these can affect the final gain or loss this systematic approach will help you navigate the complexities of indd as 109 and accurately report Financial outcomes now let's explore how accounting for trade receivables differs under indd as19 the key Focus here is the application of expected credit loss ecl methodology which marks a significant shift from the traditional incurred loss model under indas 109 entities must assess the credit risk of trade receivables at every reporting date which means adopting a forward-looking approach this involves estimating potential losses based on historical data current conditions and reasonable forecasts it's crucial to categorize trade receivables into different risk brackets applying different ecl rates accordingly this not only enhances financial reporting accuracy but also provides a clearer picture of potential risks additionally companies need to ensure robust documentation to support their ecl calculations as this will be vital during audits ultimately the emphasis on ecl under indd as 109 transforms how businesses View and manage their trade receivables fostering a more proactive riskmanagement culture now let's explore how a Company accounts for investments in equity shares with a short-term intention under indd as 109 first and foremost these Investments are classified as fair value through profit or loss or fvtpl this classification means that any changes in the fair value of these Equity Shares are recognized immediately in the profit and loss statement it's crucial to understand that this approach reflects the dynamic nature of short-term Investments Capt uring Market fluctuations in real time when the company acquires these shares they are recorded at Cost but as Market values change so do the figures on the balance sheet gains and losses from these changes are not just numbers they impact the overall financial performance and can influence strategic decisions therefore it's essential to maintain accurate valuations and timely reporting to ensure that stakeholders have a clear picture of the company's Financial Health now let's discuss discuss how a financial guarantee is accounted for under indd as 109 first it's important to recognize that a financial guarantee is a contract that requires the issuer to make specified payments to reimburse the holder for losses incurred due to the failure of a specified deor to make payments when due under indd as 109 the initial recognition of a financial guarantee occurs at fair value this means you need to measure the guarantee at the time it is issued reflecting the premium received or the expected credit loss subsequently the guarantee is measured at the higher of the amount recognized as a liability and the amount determined using the expected credit loss model this approach ensures that the financial guarantee is accounted for in a way that reflects both the risk and the potential obligation providing a clearer picture of the financial position and performance of The Entity in involved final question let's discuss how loan modifications are treated under indas 109 first it's crucial to determine whether the modification is substantial or non-substantial as this classification will significantly impact the financial reporting Begin by assessing the change in the present value of cash flows if there's a change of 10% or more it's generally considered substantial next evaluate the terms of the modified loan against the original terms look for alterations in interest rates repayment schedules or other key features if these changes are significant enough to alter the risk profile of the instrument it leans towards being a substantial modification conversely if the changes are minor such as a small adjustment in payment dates or interest rates it may be classified as non-substantial finally remember that the accounting treatment will differ based on this classification affecting how you recognize gains or losses in your financial statements as we wrap up this video I want to take a moment to reflect on what we've shared each interview has been a unique glimpse into the minds of those who navigate the complex world of Finance from seasoned experts to Fresh voices every perspective adds a layer to our understanding I urge you to watch the other videos on our Channel they're not just interviews there conversations that challenge our thinking and Inspire us to dig deeper you'll find insights on investment strategies market trends and personal finance tips that could change your approach each story is a lesson a reminder that in finance knowledge is power so dive in absorb the wisdom and let it guide your financial Journey this isn't just about numbers it's about empowerment thank you for joining us and remember the journey doesn't end here keep exploring keep learning and keep striving for financial literacy