Zero Coupon Bonds

Zero Coupon Bonds- A popular investing Option!

State-owned banks were bleeding since the past 2 years due to the Covid-19 pandemic. Considering the heavy losses that these banks suffered, the private investors weren’t exactly eager to buy the shares of these banks. At this time the RBI came up with a plan to infuse equity in these state-owned banks in the least damaging way possible. How?

By issuing Zero Coupon Bonds!

In the last 1 year, the government induced substantial amounts of capital in a few banks via Zero Coupon Bonds. Bank of India received INR 3000 crore in capital through Zero Coupon Bonds which forms about 9% of the bank’s entire equity. Central Bank of India received INR 4,800 crore and Punjab Sind Bank received INR 5500 crore from the government making the lender the highest holder of its zero coupon bonds at 87%!

What are Zero Coupon Bonds (ZCBs)?

Zero-coupon bond (also known as discount bond or deep discount bond) is a bond issued at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have a “coupon rate,” hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value.

Why are Zero Coupon Bonds a popular investing option?

Every new issue of Zero Coupon Bonds gets sold out fairly quick. Zero Coupon Bonds are a popular investing option due to multiple reasons. Some of them are:

  • Higher Yields: Zero Coupon Bonds are issued for a longer period of time. Which implies that once an investor buys the Zero Coupon Bonds, their money is locked in for a certain time period. To compensate the investors for this risk of locking in money for huge time period, issuers often pay a higher return. Which is why Zero Coupon Bonds have a higher annualised yield compared to other bonds.
  • Guarantee: The biggest advantage of Zero Coupon Bonds is their predictability. Investors are a guaranteed a full payout when these bonds mature. Which is why Zero Coupon Bonds are a good investing option for investors who have a specific financial plan in mind.
  • Liquid Market: Zero Coupon Bonds have a fairly Liquid Market. There are a lot of investors and institutional buyers who are constantly buying and selling Zero Coupon Bonds. This is why when an investor is looking to sell their Zero Coupon Bonds, they can do so without facing any risk.
  • Zero Reinvestment Risk: Zero Coupon Bonds do not pay interests periodically. Hence, investors do not receive cash periodically which they have to reinvest. Usually, the high annualized yield rate of the Zero Coupon Bonds is equivalent to the return rate if the cash flow is reinvested periodically.

The accounting & presentation of ZCBs has been substantially changed in IFRS & IndAS as compared to the erstwhile IGAAP.To understand how let us first see how these ZCBs are accounted & presented as per IGAAP.

Accounting of Zero Coupon Bonds as per IGAAP:

When Bonds are issued at less than their nominal value they are said to be issued at discount. For example, Bond of Rs. 100 each is issued at Rs. 80 per Bond for a term of 4 yrs. Under IGAAP these bonds will be accounted as follows:

Bank A/c Dr                                                                         80 

Unamortised Discount on issue of Bonds A/c Dr         20

To Bonds A/c  Cr                                                                          100

Company gets the benefit of funds by issuing Bonds over a number of years. Hence the discount is to be amortised over the term of the bond. In the given case since the term is 4 years, every year INR 5 will be written off from the Unamortised Discount on issue of Bonds A/c as below:

Interest expense A/c           Dr                                           5

To Unamortised Discount on Issue of Bonds A/c   Cr                5

What has changed under IFRS & IndAS?

As per IFRS & IndAS – 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.

The effective interest is nothing but the Internal rate of return i.e., the IRR. Hence, to account the same ZCB under IFRS we will first calculate the Internal Rate of Return (IRR) and amortise the discount over the period using the derived IRR of 5.74% as follows:

Period

Cash Flow

Gross

Discount

Outstanding

Day 0

80

100

(20)

80

Year 1

4.59

84.59

Year 2

4.85

89.44

Year 3

5.13

94.57

Year 4

(100)

 

5.43

100

Accounting entries would be:

Bank Account     Dr                                  80

Bond Liability     Cr                                                  80

(Being liability initially recognized and measured as per para 9 of IAS 39)

Interest expense    Dr                           4.59

To Bond Liability    Cr                                              4.59

(Being Interest accrued at IRR on the liability for period 1 and so on..)

Major Differences between IGAAP & IFRS:

IGAAP

IFRS

Liability is recorded at Gross value

Liability is recorded at Present value

Discount is amortised as prepaid expense over the term of bond on SLM basis

Discount is factored in while arriving at the effective interest rate of the instrument and amortised over the term.

Put on Your Thinking Cap!

  1. Do you know of any Fortune 500 companies who have issued Zero Coupon Bonds recently?
  2. As an investor, would you invest in Zero Coupon Bonds or High Risk Bonds?
  3. Other than Banks, which industry would benefit from the issue of Zero Coupon Bonds?
If you have any doubts or if you’d like to discuss about IFRS & its standards, feel free to join our next webinar ! Lastly, if you think this article would prove useful to someone, do share it with them.

The Aspects of Lease Accounting No One is Talking About!

The Aspects of Lease Accounting No One is Talking About!

Ind AS 116 – Leases, has already become effective for Companies from April 1, 2019. For listed Companies, this means that the results they declare for Q1 2019 must factor the effect of the new lease standards. Whereas the unlisted Companies have time till the declaration of their annual results for the adoption of the Standard.

Ever since the new International Accounting Standard is released, there have been many articles which highlight what are the effects of these International Financial Reporting Standards (we are talking about IFRS 16 leases here) on a company’s financial statement. So, unless you live under a rock, you would have already heard about it. To bring you up to speed, some significant implications of the new Standard are:

  1. No operating lease– all leases will be accounted as a finance lease.
  2. EBITDA Enlightenment– With rent expense converted to interest expense and depreciation, the EBITDA will show an improvement. (Well, a point to note is, EBITDA is a non-GAAP measure, i.e., not shown on the face of Statement of profit and loss. So, it’s a measure used by analysts and investors, don’t know why as interest and depreciation are recurring charge of running a business) 
  3. Changing the ratios– the lease standard brings in newer assets (Right-of-use) and liability (lease liability) leading to change in important ratios such as Return on Assets and Debt-Equity ratio. This has called for corporates having loan covenants to immediately reach out to their lenders and re-discuss these relevant matrices unless they want to end up breaching the covenant and face hassles that go with it. (Well, some people do like excitement.)

Now let us take a more in-depth look at some finer points in this new lease standard which we do not hear so much about. These are the bitter nuances not discussed in boardroom (because they are boring – I meant the details, not the board members), and expected to the handled by the finance team, who were not nominated for any Ind AS / IFRS training as they are busy working on these new Standard (Huh, the irony!).

So, here are 4 such critical aspects that should help you get a better grip on the Standard (there are many more pointers, but I think these 4 can help you get started). All these points are from the lessee perspective (come on, who talks about lessors anyway!)

  1. Short term leases or Underlying asset value is low (optional) –
  2. Short term leaseis a lease, at the commencement date, has a lease term of 12 months or less and does not contain a purchase option. Not the remaining lease term on the date of transition or period end but the total lease term estimated on inception is considered.
  3. Assets are be considered as low value in absolute term. Some examples of low value assets as given by the Standard are – tablet, personal computer, small items of office furniture and telephones.

In case of short-term lease or leases with underlying asset value is low, the Standard provides an option to either account it as operating lease or account it is Right-of-use.

What many have assumed is that if the lease fits into either of this category then it must be accounted as operating lease. Unless one realizes that this is an option, they are likely to make incorrect decision.

This is a good option to not let your loan-covenants get affected and avoid lender discussion by opting the operating lease accounting. Likewise, it may be more prudent for companies to account for all lease (even if they belong to this category) as Right-of-use, if there are volumes of such leases and if EBITDA is an important parameter.

Choices can be made only when one is aware of the options.

  1. Impact on transition –

Lessee can opt for either of the following transition approaches:

  1. Retrospectively to each reporting period– Under this approach the new lease standard is applied to all the reporting period as if the lease standard was always applied. All earlier period rental expenses are written back and the effect of interest expenses and depreciation is accounted. This results in the impact accounted in retained earnings at the beginning of the earliest reporting period i.e. while preparing the financials for Mar 2020, the comparative year end will be Mar 2019 and the effect of transition will be accounted on the retained earnings as of 1 April 2018.
  2. Retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application– This is same as point (a) with the only difference being that the effect of transition will be accounted on the retained earnings as of 1 April 2019 (the date of transition)

Certain pointers which doing the transition working are:

  • Operating lease having a remaining life of less than 12 months as on the transition date can be kept out of the working i.e., they can be continued to be accounted on straight-line basis. This is an option.
  • Lease liability will be equal to the discounted value of the remaining future lease payments
  • Right-of-use assets can be accounted at a) Lease liability on commencement of the lease term which is depreciated for the lease term lapsed. or b) lease liability on the date of transition adjusted for any prepaid or accrued lease payments (i.e., rent straight lining). Option (b) will result in no effect on retained earnings.
  • Leases accounted as finance leases under IGAAP, the value of the carrying amount of the right-of-use asset and the lease liability at the date of initial application shall be the carrying amount of the lease asset and lease liability immediately before that date measured applying Ind AS 17.
  1. Treatment on cash flows –

While determining the cash flow from operations we adjust the following 2 items (something we learned in our college days):

  1. a)     Non-operating items                                                            
  2. b) Non-cash items

Under IGAAP rental expenses was never adjusted as it is considered as an operating item, as these leased assets were used in the operating of the business. However, the new Standard replaces rental expense with interest expenses and depreciation, and it does have an impact on the cash flows as well.

The depreciation being non-cash expenses will be added back to the cash from operating activities, the payment of installment (Principal component) will be reflected under investing activity and the interest component will get classified as financing activity.

This surely put cash from operations in a positive light. This new Standard increases cash from operating activity even without a new penny of cash added to the business, beautiful isn’t it.

While all components of a financial statement are prepared on accrual basis only cash flow statement is prepared on cash basis. The entire idea of a business is to run an operating cycle and generate cash out of it and cash from operating activity is the prime indicator of how well the company can do this. This new Standard defiantly dilutes this perspective.

  1. Discount rate –

In determining the Lease liability i.e., the present value of all the future minimum lease payments a discount rate is required. This rate should be the interest rate implicit in the lease, this can be determined only if the cost of the asset is available so that the difference between the total lease value and the cost is considered as the interest component. However, it is likely that this is not available in most of the case (except for intercompany transactions).

In such a case, the discount rate can be considered as the incremental borrowing rate. The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.

So, every time a new lease it taken or there is any modification the discount rate should be worked out as per the specifics of the lease. There is no single rate that will fit all the leases and all the companies.

However, for the limited purpose of transition, if option (b) “Retrospectively with the cumulative effect of initially applying the Standard recognized at the date of initial application“  is chosen then the lessee’s incremental borrowing rate at the date of initial application can be applied.

This seems to be a nicely crafted standard (by IASB who prepared IFRS – 16, India just “converged” it) and the working and implementation can be easy if you have 10 odd leases. I did say you will be facing challenges if you have more lease and haven’t began implementation till now.

Hoping that this article will help in bringing more clarity on the Standard. Watch out this space for more insights on IFRS 16. Do share with your friends who might find it helpful.

To know more on the practical implications of IFRS 16, I invite you on my breakthrough 2.5 hour workshop where I take a deep dive on the IFRS 16 Leases in a holistic manner! To register, please click here.

 

Unexpected woe of the E-commerce Industry

Unexpected woe of the E-commerce Industry

What do you think is the biggest cause of misery for the E-commerce industry?

It isn’t Data Security, it isn’t Customer Loyalty, nor is it Competition. It is actually the Logistics surrounding cost of Sales Returns!

You will be shocked to know that the rate of Sales return in the E-commerce industry falls in the bracket of 30-35%! Yes, you read those numbers right. This implies that out of 100 products bought on Amazon or Flipkart each day, around 35 are returned by the customers! Talk about impulsive shopping! I bet this is also making you think twice before placing that return order!

Have you wondered how big players like Amazon and Flipkart account for these sales returns?

When a return order is placed, the company incurs double the cost for logistics. The previous IGAAP provided no clarity on how to account for these sales return costs, which resulted in inconsistent in attaining the objectives of financial reporting in the industry.

The introduction of IND AS and International Financial Reporting Standards has provided specific guidelines on this matter. Let us understand with the help of a case-study:

E-Mart, a leading player in the E-commerce industry sells 10,000 N-95 masks in a year. The Cost of production is INR 30 per mask and the Selling price is INR 50 per mask.

Assuming that the average sales return percentage in the industry is 30%, E-Mart expects that out of 10,000 masks sold, 3000 are bound to be returned (10,000*30%).

International Financial Reporting Standard 15 and IND AS 115 says that Sales with a Right of Return should be accounted as below:

  1. Revenue for the transferred products:

Recognized at the net amount of revenue (consideration) the entity expects to receive after the product returns have been considered into the sale.

  1. A Refund Liability:
  • A refund liability includes the expected number of returns that the entity anticipated – for which the entity does not expect to receive any consideration/revenue.
  • The refund liability shall be updated at the end of each reporting period for any changes in estimation. The adjustments shall be recognized as revenue (or reductions of revenue).
  1. An asset (and corresponding adjustment to cost of sales):
  • The entity might have a right to recover products from customers who demand a refund – this is effectively a reduction in the cost of goods sold. Thus, it shall be recognised as entity’s right to recover products on settling a refund liability.
  • At the end of each reporting period, the estimation of future returns shall be updated & the measurement of recovery asset and refund liability shall also be revised – this might result in revision of revenue recognised.

Therefore, upon transfer of control of the 10,000 masks, E-Mart will not recognize the revenue for the 3000 products that it expects to be returned.

Considering all these details, this is how E-Mart will record the above transaction as follows:

  1. Total Revenue:

For 7000 masks [10,000*(1-30%)] at INR 50 per mask = INR 350,000

  1. Total Cost:

For 7000 masks at INR 30 per mask = INR 210,000

  1. Total Liability:

To be created for expected returns of 3000 masks [10,000*30%] at INR 50 per mask = INR 150,000

  1. Total Assets:

Create a corresponding asset for its right to recover products from the customers on settling the refund liability on the 3000 masks that are expected to be returned at INR 30 per mask = INR 90,000

The return asset will be presented and assessed for impairment separately from the refund liability. E-Mart will need to assess the return asset for impairment and adjust the value of the asset if it is impaired.

Thus, the net business exposure for the sales return transaction at the time of immediate transfer of control of the masks is INR 60,000 (150,000-90,000).

To know more on the business implications of International Accounting Standards and IND AS on various sectors, attend my 3-hour breakthrough webinar to bring in an influencing organizational change. Register now: https://contetra.com/ifrs-webinar/

How the new Revenue Recognition standard has been a Game-changer for the Automobile Industry!

How the new Revenue Recognition standard has been a Game-changer for the Automobile Industry!

Did you know that the Revenue Model of the Automobile Industry has completely changed due to the implementation of IND AS 115 and IFRS 15? This has impacted the Net Profits of major Automobile Companies like Tata Motors, M&M and Ashok Leyland. Let us find out how!

What are Multiple Element Contracts?

Multiple-element contracts are when the seller provides more than one or a combination of products or services to the buyer.

What was the Revenue Recognition of Multiple Element Contracts as per IGAAP?

Under IGAAP there was no specific requirement of unbundling of services. Entire revenue was recognized upfront.

How are Multiple Element Contracts accounted as per the new Revenue Recognition Standard?

As per IND AS 115 and IFRS 15, components of sale are to be UNBUNDLED and recognized SEPARATELY at the Time of the Performance if the goods or services are DISTINCT”.

How to assess whether a good or service is distinct? – Determine through the below 2-step model:

Step 1– The customer can benefit from the good or service individually or with other readily available resources.

Step 2– The goods or services are NOT highly interrelated with other promised goods or services in the contract.

Coming back to how this changed the entire revenue recognition of the automobile industry, let us understand with the help of an example:

In April 2021, Ashok Leyland sold 50 trucks to a UPS Logistics, a leading transport company at INR 15 lakhs each. Below were the terms agreed upon between Ashok Leyland and UPS Logistics while finalizing the sale:

  1. A 5-year warranty at an additional charge of INR 1 lakh per truck. (This is optional at the buyer’s end, UPS chose to purchase the 5-year warranty)
  2. Maintenance of trucks after every 6 months for the next 2 years included in the sale price (which would have otherwise cost INR 50,000 from a third party)
  • As per IND AS 115, Ashok Leyland will first determine if each component of the sale is “DISTINCT”.

The sale components in the above transaction are:

  1. Sale of Actual trucks
  2. Sale of 5-year Warranty
  3. Sale of Maintenance Contract

Applying the above 2 steps, it can be concluded that the 5-year warranty and Maintenance Contract can be used to the benefit of the Customer individually” and are “not highly dependent on other promised goods or services in the contract”.

Which implies that each component will be unbundled and recognized SEPARATELY at the Time of the Performance.

Therefore, Revenue Recognition by Ashok Leyland will be as below:

  1. April 2021: Sale of Trucks.

  1. Warranty: A contract asset of INR 1 lakh per truck will be created for Warranty which will be deferred over a period of 5 years
  1. Maintenance Contract: Maintenance Service is provided after every 6 months for two years i.e., a total of 4 times.

Therefore, after every 6-months INR 12,500 (50,000/4) will be recognized at the time of provision of such maintenance service.

What is the impact of this changed Revenue Recognition Model on the bottom-line of the Organization?

This changed way of Revenue Recognition as per IND AS 115 and IFRS 15 will lead to a DEFERRED Revenue recognition(Warranty over 5 years and Maintenance Contract at over 2 years) rather than upfront recognition as per IGAAP leading to a direct impact on the EBITDA and Net Profits of Ashok Leyland!

Let me know in the comments below if you found this insightful!

To know more on how the new Revenue Recognition Standard will have an impact on the bottom-line of the organization & to Once & for all uncomplicate the technically daunting IFRS 15 standard on Revenue from Contracts with Customers, attend my 2.5 hour breakthrough workshop on “IFRS 15: Deep Dive- to Practically Understand Revenue Recognition! Register Here

The Dilemma of Combining Contracts as per IFRS 15!

Hello fellow finance enthusiasts,

Did you know that after the introduction of the new IFRS 15 standard, one of the most contentious issues & challenges is – when should an entity combine two or more contracts as a single contract?

Let’s understand with the help of a simple example:

Oracle Inc (a leading IT company), entered into a contract with the Indian Oil Corporation Ltd to create a fully automated procurement system that would save their time immensely. Two weeks later, Oracle Inc entered into a similar contract with Bharat Petroleum Corporation to sell the same system.

Both Indian Oil Corporation and Bharat Petroleum are controlled by the Ministry of Petroleum and Natural Gas, i.e., both the companies are Government-owned. While negotiating the contract with these entities, Oracle Inc consented to provide a deep discount only if both the companies agreed to purchase the Automated procurement system from Oracle Inc.

Oracle Inc. is in a dilemma as to whether to account for this as 2 separate contracts or a single contract? Let us solve the dilemma as per IFRS 15!

If two or more contracts are entered “around the same time and “with the same customer, they can be accounted for as a single contract, if any one of the following are met:

  • Criteria 1: The contracts are negotiated as a package with a single commercial objective.
  • Criteria 2: The consideration of one contract depends upon the Price or Performance of the other contract.
  • Criteria 3: The goods or services promised in the contract are not distinct i.e., they qualify as a single performance obligation.

Important Note: A judgement needs to be made by the entity if the contracts are entered “around the same time” as the standard does not provide a specific period to define such term.

Coming back to Oracle Inc’s dilemma,

Both Indian Oil Corporation and Bharat Petroleum are owned by the Government of India, which means that the contracts are entered with the same customer.

The contracts are entered within two weeks, and it would be safe to assume that this classifies as ‘near same time for Oracle Inc.

It is evident from the negotiations of Oracle Inc. that services would be provided at a discount only when “BOTH” the government owned entities purchase the automated system. This implies that the contracts are negotiated with a single commercial objective and consideration of one contract is dependent on the other contract.

Oracle Inc. thus fulfils not just one, but two criteria which are stated above.

Thus, the contracts with Indian Oil Corporation and Bharat Petroleum should be accounted for as a single contract by Oracle Inc.

If you have encountered a situation where you had to determine whether two or more contracts should be combined or not, let me know in the comments below!

To know more on how the new Revenue Recognition Standard will have an impact on the bottom-line of the organization & to Once & for all uncomplicate the technically daunting IFRS 15 standard on Revenue from Contracts with Customers, attend my 2.5 hour breakthrough workshop on “IFRS 15: Deep Dive- to Practically Understand Revenue Recognition! Register Here.

Why are Convertible Bonds more appealing than Equity or Debt?

Hello finance professionals! Today let’s talk about why Convertible Bonds are once again picking up steam as a popular investing choice for institutional investors, venture capitalists and equity investors.

Amidst the volatile markets of the pandemic, a huge number of start-ups and companies with a cash-crunch found that raising money through hybrid instruments like convertible bonds was a more lucrative choice compared to traditional equity or debt. And the numbers don’t lie. In the year 2020, more than $188 billion in convertible bonds were issued worldwide.

Interestingly, the last time the world saw such a surge in popularity of convertible bonds was way back in 2008 (during another time of global uncertainty), when the amount of convertible debt issued was more than $86 billion.

To understand the business advantages of issuing convertible bonds, let’s take the example of Southwest Airlines.

Southwest Airlines offers customers the flexibility of high-speed transport with frequent and flexible departures at low-cost prices, focusing on friendly service, speed, and frequent point-to-point departures; without incurring extra costs in providing meals and lounge service.

In this way, they managed to become the country’s largest domestic air carrier, capturing more than 25% share of the domestic air travel market in the US, with this strategy that has proved effective for almost 5 decades.

When global travel was halted in April 2020, Southwest issued $2.3 billion 1.25% convertible note (due in 2025), to help the company with an influx of cash which would help it tide uncertain times. The conversion price was set at $38.48 per share.
Note: the market price of the share around that time was approximately $28. As of 16 November 2021, the share price was hovering around $48.

Why are convertible bonds so popular during volatile times?

For Companies:

–        Lower revenues due to imposed lockdowns and travel restrictions

–        Uncertain times lead to higher cash flow burn rates

–        Liquidity crunches faced in difficult times

–        Effective way of raising capital for start-ups and unproven businesses that are in capital-draining businesses

–        Ownership is not immediately diluted, unlike an issue of equity

–        The interest rate offered can be lower as compared to an out-and-out bond since investors are provided with the equity upside

For Investors:

–        Those who expect the company to do well and make a healthy turn-around, find convertible debt to be an attractive option.

–        Such a “recovery type trade” or “rescue finance” invariably offers more equity upside: the option to convert into stock once the stock prices bounce back is more valuable than redeeming the value in cash.

–        The stock option within a convertible debt is always priced at the mid-point, reflecting both: the demand for the convertible instrument, the recovery potential of the company as well as taking cognizance of the current market situation

 

Thus to put it simply, convertible Debentures offer the advantages of equity while negating the risk of uncertainty with its bond-like features.
It enables investors to be a part of the growth or turnaround story of the company without the inherent risks of traditional equity investing.

More about the Instrument: Convertible Debt

Just like any other debt or bond, convertible debentures are issued with a fixed coupon rate, a maturity date, and a redemption value. They also include a conversion option (at the option of the holder or the issuer) which allows an exchange of a certain number of shares of the issuer’s company at the time of redemption of debentures instead of cash.

When will the bonds convert (and how will an investor gain from it)?

The conversion price of the convertible bond at the time of its issue is typically more than the company’s current stock price. As we saw in Southwest’s case, the conversion price was $38.48 compared to the stock price at that time of $28). At the date of redemption, there are two possibilities:

  1. The share price rises: The fair value of the convertible bond will also increase as it has a direct relationship with the movements of the share price.
  2. The share price decreases: The investor will still get the agreed upon conversion value. This par value of the bond, which will prevent the holder from Equity-risk, is known as “Bond Floor”.

The conversion ratio of such instruments is generally set at a price which is at a premium of around 30-40% of the existing share price. Thus the option is “out of the money” (see the red area in the chart above) until the share price goes above the bond floor price (PV of coupon payments and par value of the instrument).

Now that we’ve discussed convertible bonds at length, let us find out how they’re presented and accounted for as per IFRS 9, with a simple example:

Let’s assume Sunshine Ltd. issued 1,000 nos. convertible bonds maturing in 5 years, with a face value of INR 1,000 each. They carry a coupon rate of 4% per annum, payable annually at the end of the year.

At the option of the holder, the bonds can be converted into equity shares instead of cash redemption at the end of 5 years.

The total proceeds received are thus INR 10,00,000. Market rate of interest for bonds without a conversion option is 6%.

Classification as per IFRS 9: It is a compound financial instrument as it contains the below 2 elements:

  • Liability component = Sunshine’s obligation to pay fixed coupon & redemption value in cash (if the holder chooses that option)
  • Equity component = Bond holder’s option to get the bonds converted into shares after 5 years (instead of a fixed cash amount)

 

Now that we have understood the concept, let us see how to account for this compound financial instrument:

Step 1 Determine fair value of the liability component. Make a simple table of Discounted Cash Flows.

Year

Coupon (4% x 10,00,000)

Principal Repayment

Total Cash Flow

Discounting Factor (at 6%)

Present Value

1

40,000

 

40,000

0.9434

37,736

2

40,000

 

40,000

0.8900

35,600

3

40,000

 

40,000

0.8396

33,585

4

40,000

 

40,000

0.7921

31,684

5

40,000

10,00,000

10,40,000

0.7473

7,77,148

 

 

 

 

Total

9,15,753

 

Thus, present value of the liability component is INR 9,15,753.

Step 2 – Assign remaining residual value to the equity component.

The residual amount of INR 84,247 (10,00,000 – 9,15,753) is thus, the equity component.

Step 3 – Accounting Entry for Initial Recognition

Particulars

Debit

Credit

Cash

10,00,000

 

     To Convertible Bond

 

9,15,753

     To Equity (Convertible Bond)

 

84,247


After initial recognition, the equity component will not be re-measured. The liability component will be accounted for at effective interest rate method as per IFRS 9.

Put on Your Thinking Cap!

  • Are you aware of any start-up that has recently raised capital through hybrid instruments? (let me know in the comments below!)
  • Did you know that until recently even Tesla Motors used to be a big issuer of convertible debt instruments?

If you have any doubts or if you’d like to discuss IFRS 9, feel free to drop me a line on my LinkedIn profile! Lastly, if you think this article would prove useful to someone, do share it with them.

Sources: The Economist, Bloomberg, Blue Ocean Strategy by Harvard Business Review Press, Investopedia.com, Calamos Investments.

How Misinterpretation & Non-Compliance of IFRS can cost you dearly!

Hello fellow-finance professional!
I wanted to share a few astonishing facts from an interesting session that I recently conducted on IFRS 9 – Financial Instruments:

  • In India, the estimated cost of financial non-compliance across financial firms was $5.5 billion in 2020
  • Businesses in the U.S. have spent $10,000 per employee on an average on regulatory costs (These include fines, penalties, litigations, arbitrations and other financial damages).
  • In the five-year period between 2013-14 and 2017-18, India Inc’s regulatory compliance costs have increased by 56.73% (from INR 14,486 crores to INR 22,705 crores). This percentage has been increasing since then. (Interestingly, this was also the time that IFRS was first implemented in India – through IndAS)
  • On a year-on-year basis, legal and professional fees went up by more than 4%.

What is the biggest reason behind such non-compliance?

The top reasons that have been identified behind non-compliance by corporates are:

  • Lack of knowledge of the regulatory laws and reporting practices.
  • Incorrect understanding of the regulatory requirements.
  • Failing to practically implement the laws and regulations accurately.

Under these circumstances, corporates place high value on employees who can help avoid or prevent companies from incurring such high regulatory costs!

Hence, it becomes imperative for finance professionals to acquire a thorough understanding of the Financial Reporting Framework, so that they can add significant value to their firm, and shine as a professional.

In a previous blog, I discussed how to determine if preference shares are debt or equity, and some real-world examples on their effect on the Debt-Equity ratio of a company. Read it here!

Today, we will find out how misinterpreting IFRS 9 led this large private-sector bank to be slammed with an INR 2 crore penalty!

As per the Reserve Bank’s licensing norms, a private bank’s promoter holding has to be brought down to 40% within 3 years of operations, 20% within 10 years and 15% within 15 years.

In line of this, RBI mandated Kotak Mahindra Bank Limited to reduce its promoter shareholding to 20% by December 31, 2018. To comply with the same, Kotak issued perpetual non-convertible preference shares which it said would reduce promoter stake from 30.3% to 19.7%.

The bank was of the opinion that this class of preference shared would be a financial liability and will not form part of equity. However, for preference shares to be considered as liability or debt, the following must also be true:

– there must be fixed percentage of dividend, and a contractual obligation to deliver cash
– the bank (issuer) must mandatorily redeem the preference shares for a fixed/determinable amount at a future date
– the holder must have the right to require the bank (issuer) to redeem the shares at a future date for a fixed/determinable amount.

In the absence of the above, the RBI did not agree with the classification of the instrument as a financial liability and maintained that the class of instruments continued to be “equity” instruments, with the promoters retaining their voting rights and stake.
The Reserve Bank went on to impose a penalty of INR 2 crores on Kotak Mahindra Bank Limited for non-compliance in dilution of promoter’s shareholding!

This is how the implications of IFRS 9 with regards to classification of Financial instruments, can have significant financial and legal impact on your business!

Put on Your Thinking Cap!

After understanding how misinterpreting the reporting standards can have a grave financial as well legal impact on companies, I hope you will now be able to assess:

  • Whether such class of preference shares exist in your organization?
  • Whether you have classified it accordingly?
  • Have you identified any areas which are highly vulnerable to non-compliance in your organizations?
  • What steps are you taking to ensure that you and your team comply with all regulations and Reporting Framework accurately?
  • Do you feel the need to take an experts advice while interpreting Financial Reporting Standards in your organization?

I would love to discuss these in detail with you. If you have any doubts or if you’d like to discuss IFRS 9, feel free to drop me a line on my LinkedIn profile! Lastly, if you think this article would prove useful to someone, do share it with them.

 

(^Sources: Mint, Lexisnexis, Economic Times, hyperproof, forbes, BusinessStandard, Reuters)

Can IFRS 9 – Financial Instruments impact your Company’s Existing Leverage Ratio?

While it is a general perception in the financial world that IFRS 9 – Financial Instruments could result in volatility in reported income of many companies (on account of assets being measured at fair value, and resulting change being reflected in the statement of profit and loss) – there is another significant impact of this standard on the “leverage” ratio on the financial statements of many companies.

What is leverage and leverage ratio?

In business terms, leverage means debt i.e., external fund (Borrowing) can be “leveraged” to increase the returns of a company. One of the most important leverage indicators (the Debt-to-Equity ratio) essentially shows the proportion of a company’s funds sourced from debt and how much are sourced through owners’ equity.

What is an optimal Debt-to-Equity ratio?

Exactly how much debt is ideal for a business depends on the company’s requirements from time to time and the company’s nature of operations.

For instance, capital-intensive industries such as manufacturing commonly have higher levels of debt than say, a company operating in the service industry such as Information Technology industry.

 

A classic example of the above: The Debt-to-Equity ratio of Tata Motors as of 31 March 2021 was 2.08 times (meaning debt is twice the amount of shareholder capital). Since the company is an automobile manufacturer requiring heavy infrastructure generally requires higher debt to fund the purpose of operating assets. As the borrowings are backed by capital assets a leverage of more than 2 times would not be so alarming.

In contrast, the Debt-to-Equity ratio of Tata Consultancy Services is 0, despite being a part of the same group of companies (Tata Sons). This proves that what is regarded as a healthy Debt-to-Equity ratio will vary from industry to industry and business to business!

An interesting point to consider here is: Do you think TCS is over-relying on equity funding? Let me know in the comments!

 

 

How one of the biggest Indian conglomerates aspires to become a debt-free company!

In a bold (and boastful?) move, Reliance Industries Ltd. chairman Mukesh Ambani declared in July 2020 that RIL had ambitions to become Net Debt-free! Which essentially meant the company had enough cash and marketable securities to pay off its existing debt.

To that end, the company repaid more than USD 21 Billion of its debt after raising over USD 44.4 billion of capital (including noteworthy investors like Facebook and Google’s acquisition of around 18% stake in Jio worth USD 10.2 billion), which was the largest ever capital raised by any company in a year globally.

This resulted in a decrease of more than 35% in the debt-to-equity ratio from 0.65 in March 2020 to 0.41 in March 2021!

 

A Major wave of Deleverage in the Steel Industry!

Another recent example of de-leveraging: While an increase in global steel prices might have been a cause of concern for end-consumers, it was a dream run for the major steel players in India, who went on a de-leveraging spree – managing to pay off a whopping 15% to 35% of their total debt by taking advantage of the global price rise! The below table illustrates the considerable decrease in Debt-to-Equity ratio for this capital-intensive industry:

 

Why is the Debt-to-Equity ratio an important financial metric?

  • The debt-to-equity ratio is often used while applying for a business loan or line of credit. Banks will take an account of the industry’s average ratio and compare the same with the company’s debt equity ratio to determine the credibility of the business.

  • For investors, the debt-to-equity ratio is used to indicate how risky it is to invest in a company.
    Generally, the higher the debt-to-equity ratio, the riskier the investment since it indicates that the company already has a significant amount of debt – however this must be assessed in conjunction with the industry standard.
  • It can help lenders to ascertain on whether to impose a debt covenant on the borrower i.e., (placing restrictions on the overall borrowing limits of the borrower while lending them money) – Often these limits are monitored by the debt-to-equity ratio.

Now that we have understood the significance of Debt-Equity ratio, let’s understand how IFRS and its principle of substance over form can impact the leverage ratio even without raising any additional capital!

How a major entertainment conglomerate’s Debt Equity ratio was adversely impacted after adopting IFRS 9?

Pre-Ind AS Scenario:

The said entertainment conglomerate had in its balance sheet “redeemable preference shares” which are preference shares issued to shareholders having a callable option implanted by default. This implies that the company can repurchase this class of shares against cash from the shareholders at the end of a fixed term.

The price at which a company can repurchase these redeemable preference shares is already decided at the time of issuing such shares.

Before the adoption of Ind AS (Converged IFRS), Redeemable preference shares were classified and accounted in the Financial Statements under “Equity”.

Impact of IFRS 9: In 2015, post the first-time implementation of Ind AS / IFRS, the media conglomerate (Zee Entertainment) had to classify their Redeemable Preference Shares as Debt which adversely impacted their Debt Equity ratio (leverage) by 0.6 times (vs. 0 times)!

This is because as per IFRS 9, Compulsorily Redeemable Preference Shares contain an “Obligation to pay” and therefore had to be classified as debt in the Financial Statements!

As a stakeholder, this would also mean that the Preference share dividend would now be recognized as an interest expense in the Statement of Profit & Loss instead of being an appropriation out of profit as was the case earlier.

What ‘Substance over Form’ principles would be taken into consideration in determining if Preference shares are Debt or Equity?

  • Are the preference shares redeemable at a fixed date?
  • Does the option to redeem held by the holder of the shares?
  • Are the payments to be made (whether as interest or dividends) mandatory for the issuer?
  • Whether a specific percentage of profit obligated to be distributed to the holders?

When the answer to the above questions is yes, the preference shares would be recognized as a Financial liability (Debt) as per IFRS 9. This is because the issuer has a definite obligation of delivering a financial asset or cash to the holders of the instrument. However, if the answers to the above questions are mixed, then the classification would vary from case to case.

Put on Your Thinking Cap!

 

After understanding the implications of IFRS 9 on debt-equity ratios, I hope you will now be able to assess:

  • Whether such class of Preference shares exist in your organization?
  • Whether you have classified it accordingly?
  • If classified correctly, whether you have been accounting for it appropriately?
  • Did such a reclassification impact your company’s leverage ratio?

I would love to discuss these in detail with you at my 2.5 hours breakthrough webinar where I “practically decode Financial Instruments Using ECL Template” and get to the Business-impact of IndAS/ IFRS using real-world case studies! Register for the workshop here. (Limited seats only)

Impact of Contracts Modification on Manufacturing Companies Under IFRS 15

One of the critical IFRS standards, IFRS 15, is based on the revenue from contracts with customers. While the ultimate goal of this standard is to achieve revenue recognition, there are different criteria that need to be fulfilled for the same. For example, the important things to be in order are as described under:

  • The selling price is fixed or determinable from the company to the customer
  • A reasonable evidence of the arrangement is in place between the company and the consumer
  • Final rendering of services or delivery of products has happened

While many companies still do not realise the impact of IFRS 15, it is crucial to note that companies belonging to different sectors may have to focus on different aspects of this important IFRS standard. Say for manufacturing companies, there will be cases when they are required to deliver their total order in short bursts – i.e., delivering some quantity at regular intervals of time, especially for very large orders. Let us understand the potential impact of IFRS 15 on a manufacturing company that has a contract in place with a customer for one of its products and then the contract undergoes modification for the same product.

Scenario

Take for example, a manufacturing company ABC that produces office chairs. It has an order of 900 chairs for total cost of INR 9,00,000 (INR 1000 per chair) from two different IT companies XYZ and DEF. For these orders, there is one contract each in place between ABC and the respective companies XYZ and DEF. Considering the magnitude of the order, the manufacturer (ABC) agrees to deliver equal number of chairs in 3 separate phases (over next three months) – making it 300 chairs per delivery for both the customers.

Now, after the first delivery of 300 chairs, XYZ demands for an additional 300 chairs over and above the earlier order of 900 chairs. For this additional order, ABC offers a volume discount to XYZ (a discount it normally offers to most of its clients ordering similar quantity of chairs), making it INR 900 per chair (total INR 2,70,000 for 300 chairs). So, they modify the contract for a total order of 1200 office chairs.

At the same time, after first delivery of 300 chairs, DEF demands for the same number of additional chairs (300) over and above the initial order of 900 chairs. Now, ABC decides to give a better volume discount to DEF as it expects more bulk orders from this particular client. So, it decides to offer the additional 300 chairs at just INR 800 per chair (total INR 2,40,000 for 300 chairs).

In such a scenario, how will the revenue be accounted for from the contract between ABC and XYZ, as well as from the contract between ABC and DEF, considering the entire order gets delivered that year?

Under Earlier Guidelines of IAS 18

In case of IAS 18, the revenue for the order delivery is taken into account at the time of delivery, and there is no requirement to consider stand-alone selling price of the products for the add-on order.

Revenue for that year (under IAS 18) from contract between ABC and XYZ =

INR 9,00,000 for the initial order of 900 chairs + INR 2,70,000 for the additional order of 300 chairs = INR 11,70,000 (for all the 1200 office chairs delivered)

Revenue for that year (under IAS 18) from contract between ABC and DEF =

INR 9,00,000 for the initial order of 900 chairs + INR 2,40,000 for the additional order of 300 chairs = INR 11,40,000 (for all the 1200 office chairs delivered)

Under New Rules of IFRS 15

In case of IFRS 15, this typical contract modification can be classified into two types:

1.Separate Contract

2.Not a Separate Contract

The contract modification is considered as a separate contract (original contract is considered as it is) when the following is fulfilled:

  • The add-on products / services in the contract modification should be distinct from the products / services in the original contract.
  • Amount considered for the products / services in the additional order should reflect the stand-alone selling price of those products / services.

If any or both of the above two criteria for a separate contract are not fulfilled, then, the contract modification is not a separate contract.

For the above scenario, the first criteria is met since the office chairs in the additional order are distinct from the ones in the initial order. So, the revenue recognition for the order from companies XYZ and DEF depends wholly on the second criteria about the amount of products (chairs) reflecting their stand-alone selling price.

For XYZ, the discount offered is a standard one which the manufacturer generally offers to every customer ordering this number of office chairs. Here, the price quoted in the add-on order reflects the stand-alone selling price of these office chairs. Thus, the subsequent contract modification is considered as a separate contract (resulting in the price change being considered only for the additional chairs ordered) and we have the calculation as under:

Revenue for that year (under IFRS 15) from contract between ABC and XYZ =

INR 9,00,000 for the initial order of 900 chairs + INR 2,70,000 for the additional order of 300 chairs = INR 11,70,000 (for all the 1200 office chairs delivered)

However, for DEF, the discount offered is much higher than the normal discount that the manufacturer offers generally to its customers, because it expects a long- term association with DEF. So, in this case, the price quoted for the chairs in the add-on order does not reflect their stand-alone selling price. Thus, the subsequent contract modification is considered as not a separate contract, but a part of the original contract itself. In simple words, the price change becomes applicable not only for the additional chairs ordered, but also for the chairs ordered as part of the original contract that were not delivered at the time of contract modification. So, we practically have to consider the revenue recognition before contract modification and after contract modification as under (for contract of ABC with DEF):

  1. Before contract modification

Transaction price = INR 3,00,000 for the 300 chairs delivered from the initial order (before contract modification; at INR 1000 per chair)

      2.  After contract modification

Overall Transaction price = INR 6,00,000 for the 600 chairs that were undelivered from the initial order (at the time of contract modification; at original price of INR 1000 per chair) + INR 2,40,000 (for the additional 300 chairs at discounted price of INR 800 per chair) = INR 8,40,000 for 900 chairs delivered after the contract modification

Thus, the price per chair post contract modification comes out to be INR 933. 33 ( 8,40,000 / 900). Thus, final revenue recognition for contract modification between ABC and DEF is done as under:

Revenue for that year (under IFRS 15) from contract between ABC and DEF =

INR 3,00,000 for the 300 chairs delivered from the initial order (before contract modification; at INR 1000 per chair) + INR 8,39,997 for the 900 chairs delivered after contract modification (at INR 933.33 per chair)

= INR 11,39,997 (for the total 1200 chairs)

 

Final Takeaway

Upon above comparison, the total revenue for contract between ABC and XYZ is the same under IAS 18 and under IFRS 15. And it is the same case for contract between ABC and DEF. So, what has been the impact of IFRS 15? Well, the timing of revenue is quite different. And this can have a significant impact on the taxes, financial ratios, dividends, etc. And as a manufacturing company, you need to be cautious about several things such as:

-Whether to recognize revenue over a period of time or at that point of time?

-How to take into account the contract modifications?

-How do you offer volume discounts to your customers?

To learn IFRS 15 and other IFRS standards from the industry subject matter experts, do check out our IFRS Acumen and Diploma in IFRS courses.

Cheers!

Ramanujam Narayan

Business Head – Finance First | CFO – ConTeTra Universal LLP

Reading a Company’s Financial Statements

Any company’s financial statements across the world, are presented in the most boring document called “The Annual Report”. It is the antithesis of a suspense thriller unless you are a banker who has lent huge money to the company for a very long tenure. In fact, I prescribe it as the surest cure to insomnia. I also provide money back guarantee, if you don’t fall asleep by the 6th page itself.

Jokes apart, annual report is the most comprehensive report on company’s performance, its financial health and the cash resources that the company has with itself, at a given point in time. And since I said in the first para, that it is boring, there is an approach to read it.

Don’t start from the start. Don’t jump to balance sheet either. The best way to start reading the company’s financial statements is to start by reading, “Director’s Salary”. I got you again.

For listed Indian Companies, they have a section, called “Management Discussion and Analysis (MDA) “of financial statements. SEBI (Securities & Exchange Board of India) makes it mandatory for Indian companies to provide the top management’s view on financial statement of the company. In this section, the board writes about the economy, industry, the competition, company’s performance for the period presented and much more. In fact, if you take up an industry and read the MDA for five companies of that sector, you would get a wholistic perspective of how it functions.

The same information can be found in, “The Directors Report” for foreign companies. By knowing this information about your sector, you come across as a person who knows his stuff. This, I would also classify as smart work, since this section is not more than 10 % of the total annual report. This is the essence that one must read.

They say that respect is earned and not demanded. Equipped with this information, I am sure, in your company meetings, people would come across and say, that this person doesn’t open his mouth much, but whenever he does, he makes sense.

For more insights about related topics on finance and to be on top of your business finances as well as numbers:

Grab One of the BestSeller Books in Finance on Amazon India:https://amzn.to/2BHsQir

Subscribe to this Finance YouTube Channel that has Crossed Millions of Views:https://www.youtube.com/user/FinanceTubebyVishalT

For any finance related queries or experiences / learning similar to the ones described above, feel free to write to me at vishal.thakkar@contetra.com or drop a message on my LinkedIn inbox.

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