1.   Application of IRR on HFT categorized instrument

Enquiry:

This is with reference to the requirement of para 30 of IAS-18 “Revenue Recognition” which states that:
“Revenue shall be recognized on the following bases:

a) interest shall be recognized using the effective interest method as set out in IAS 39, paragraphs 9 and AG5–AG8;…………….”

Para 9 of IAS-39 states that:
“The effective interest method is a method of calculating the amortized cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument (for example, prepayment, call and similar options) but shall not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see IAS 18 Revenue), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to estimate reliably the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).”

Linking the requirement of IAS-18 with the para 9 of IAS 39, IAS-18 para 30 require the recognition of markup income using effective interest rate method which in the light of IAS 39 para 9 will result in amortized cost of the instrument irrespective of the category. That suggests that whenever one applies the effective interest rate methodology, it consequently will impact the amortized cost of the instrument. It is important to note here that IAS-18 did not put any restriction of the classification of instrument i.e. through PL, AFS and HTM.

Our deliberation to above mentioned requirement for an instrument that is classified in HFT or Through Profit or loss category are narrated as;

Income to be recorded on effective interest rate method

It resultantly will have impact on the amortized cost (carrying cost) of the instrument. As the instrument is classified as HFT /Through P&L, it needs to be mark to market at the current market price. The impact on amortized cost of the instrument would ultimately have implications of unrealized gain / loss as well.

Let’s check this numerical example;

Example of calculating amortized cost; debt instrument with stepped interest payments

Sometimes entities purchase or issue debt instruments with a predetermined rate of interest that increases or decreases progressively (stepped interest) over the term of the debt instrument. If a debt instrument with stepped interest and no embedded derivative is issued at CU 1,250 and has maturity amount of CU 1,250,

On 01 January, 2000 entity A issued a debt instrument for a price of CU 1250. The principle amount is CU 1250 and the debt instrument is repayable on 31 December 2004.The rate of interest and market value of the instrument each year would supposed to be as follows;

Year	Interest Rate	Market Value
2000	6%	100
2001	8%	101
2002	10%	102
2003	12%	103
2004	16.4%	104

Effective interest rate comes out to be 10%.

Impact Analysis on income statement of such an instrument classified as Held for Trading with markup recognized on IRR basis and instrument carried at market value would be as follows; (keeping other factors remains constant it is presumed that market rates will exactly move in upward direction to reflect the increasing return scenario of the instrument.)

Year	Carrying Cost Beginning	Interest Income (IRR)	Cash Flows	Amortized Cost	Market Rate (FV)	Market Value
2000	1250	125	75	1300	104.00	1300
2001	1300	130	100	1330	106.40	1330
2002	1330	133	125	1338	107.04	1338
2003	1338	134	150	1322	105.76	1322
2004	1322	133	1250+205	–

Adding a little adjustment in the above scenario, suppose the market rate of the instrument is constantly reported as 100 for all four years despite the increase in interest rate of the instrument each year which is a case with most of instrument for which valuation is provided in the industry by one of the association.

Now there will be nil impact of IRR on the income statement as the incremental markup based on IRR will be offset exactly by the unrealized loss on revaluation.

Year	Carrying Cost Beginning	Interest Income (IRR 10%)	Cash Flows	Incremental income based on IRR	Principle repaid	Amortized Cost	Market Rate (FV)	Market Value	Unrealized (loss) for Year
	A	B=A*IRR	C=FV*Int rate	B-C		A+B-C
2000	1250	125	75	50		1300	100	1250	(50)
2001	1300	130	100	30		1330	100	1250	(30)
2002	1330	133	125	8		1338	100	1250	(8)
2003	1338	134	150	(16)		1322	100	1250	16
2004	1322	133	205	(72)	1250	–			72

We would like to seek opinion of the technical committee of The Institute of Chartered Accountants of Pakistan on the implementation of requirement of IAS-18 para 30 (a) read with IAS-39 para 9 using the illustration above for HFT / Through P/L categorized instrument.

Opinion:

The Committee examined your enquiry and appreciates the concerns raised by you in the enquiry. The Committee would like to draw your attention to the following para of IFRS 7 ’Financial Instruments: Disclosures’: (underline is ours)

20 An entity shall disclose the following items of income, expense, gains or losses either in the statement of comprehensive income or in the notes:

a. …………….

b. total interest income and total interest expense (calculated using the effective interest method) for financial assets that are measured at amortised cost or financial liabilities not at fair value through profit or loss. ………..

The Committee is of the view that for financial assets at fair value through profit or loss, there is no need to distinguish between the fair value changes and interest income and dividend or expense. However, fair value changes (net gains or net losses) on such instruments should be presented separately, if they are material. If interest income or expense includes both amounts from instruments at fair value through profit or loss and amounts from instruments not at fair value through profit or loss, then the disclosure of total interest income and total interest expense for financial assets that are not at fair value through profit or loss is required.

In addition, if interest is presented separately, then it should be measured on an effective interest basis and presented as interest income or expense. Your attention is also drawn to the following paras of IFRS 7 and IAS 1: (underline is ours)

IFRS 7

BC34 Some entities include interest and dividend income in gains and losses on financial assets and financial liabilities measured at fair value through profit or loss and others do not. To assist users in comparing income arising from financial instruments across different entities, the Board decided that an entity should disclose how the income statement amounts are determined. For example, an entity should disclose whether net gains and losses on financial assets or financial liabilities measured at fair value through profit or loss include interest and dividend income (see Appendix B, paragraph B5(e)).

B5(e) Paragraph 21 requires disclosure of the measurement basis (or bases) used in preparing the financial statements and the other accounting policies used that are relevant to an understanding of the financial statements. For financial instruments, such disclosure may include:

(a)-(d) ………..

(e) how net gains or net losses on each category of financial instrument are determined (see paragraph 20(a)), for example, whether the net gains or net losses on items at fair value through profit or loss include interest or dividend income.

IAS 1

1.35 In addition, an entity presents on a net basis gains and losses arising from a group of similar transactions, for example, foreign exchange gains and losses or gains and losses arising on financial instruments held for trading. However, an entity presents such gains and losses separately if they are material.

1.82 As a minimum, the statement of comprehensive income shall include line items that present the following amounts for the period:
(b) finance costs;

The Committee is also of the view that the total of interest and other fair value change (gains/ losses) should not exceed the total of fair value changes (i.e. the changes in presentation will not affect the net results in the income statement).

In addition, the entity should also disclose within its accounting policies whether or not interest income and expense on items at fair value through profit or loss are separated.

The above may be illustrated (case A and B) as follows:

CASE A – POSITIVE FAIR VALUE CHANGES

	2011	2012
Fair value of financial assets	Rs. 100	Rs. 80
Total changes in fair value (100- 80)	Rs.20
Interest income at effective interest basis	Rs.5

 

CASE A – SOLUTIONS
Option 1 – Interest presented separately – at effective interest basis

	2011	2012
Balance sheet	—- Rs ——
Financial assets at fair value through profit or loss	100	80
Income statement
Net changes in fair value (20- 5 interest)	15
Interest income at effective interest basis	5
Total Income	20

 

Option 2 – Interest is not presented separately
	2011	2012
Balance sheet	——- Rs ——
Financial assets at fair value through profit or loss	100	80
Income statement
Changes in fair value (20- 10)	20

 

CASE B- NEGATIVE FAIR VALUE CHANGES
	2011	2012
Balance sheet	——– Rs —–
Financial assets at fair value through profit or loss	65	80
Total changes in fair value (65- 80)	(15)
Interest income at effective interest basis	5

 

CASE B – SOLUTIONS
Option 1 – Interest presented separately –at effective interest basis
	2011	2012
Balance sheet	—– Rs ———
financial assets at fair value through profit or loss	65	80
Income statement
Net changes in fair value ( (-15) – 5 interest)	(20)
Interest income at effective interest basis	5
Total Income	(15)

Option 2 –Interest is not presented separately
	2011	2012
Balance sheet	—– Rs ———
Financial assets at fair value through profit or loss	65	80
Income statement
Changes in fair value (80- 65)	(15)

(June 27, 2012)