NFRA Circular - Derecognition of Financial Liabilities - Ind AS 109

Clarification in the addendum to NFRA circular no. NF-20511/5/2022-O/o Secy-NFRA dated 20.10.2022

Background:

Recently, the National Financial Reporting Authority (NFRA) which is a supreme institution monitoring the compliance with the Financial Reporting framework in India (Ind AS) issued a circular clearly refraining all the entities which are preparing their financial statement as per Ind AS for not to discontinue recognition of interest cost on borrowings which have become a NPA for the banks.

NFRA has observed and as stated in its circular, a listed entity has discontinued recognizing interest upon its borrowings from a bank based upon the fact that the lender bank has classified the borrowing as Non-performing Assets (NPA) and the Company is in the process of negotiating a one-time settlement with the banks. Original circular attached herewith:

From the understanding of Ind AS 109, a borrowing being a financial liability shall be classified and measured at amortized cost using the effective interest rate method (EIR). The interest cost under the EIR method is recognized using the market interest rate or incremental borrowing rate (the details of the method will be discussed below).

While the NFRA has clearly stated in a 2-pager notification that it is a non-compliance with the accounting standards, it is futile to move towards any other conclusion but it is pertinent for the user of the financial statements and the management to re-iterate the guidance given in Ind AS 109 and take an opportunity to revisit their stands in terms of the classification, measurement, and derecognition of financial instruments and its treatment in their books.

This document is only providing further clarification on Ind AS 109 Financial Instruments and reproducing the guidance while trying to address the elephant in the room.

The objective of this document:

The objective of this document is only from the educational perspective and to increase awareness about the guidance that is already present in Ind AS 109 or IFRS 9 Financial Instruments which has wider guidance available on global platforms.

Issue at the hand:

Whether the classification of a Loan as NPA by a lender bank as per RBI guidelines will be tantamount to liberty to the entity to discontinue the recognition of interest cost on its borrowings?

Analysis:

As per Ind AS 32 Financial Instruments: Presentation, Financial Liability is any liability that is

a)??????a contractual obligation:

?????????i.?to deliver cash or another financial asset to another entity (e.g. a payable)

????????ii.?to exchange financial assets or financial liabilities with another entity under?conditions that are potentially unfavorable to the entity (e.g. a financial option written by the entity); or

b)?????a contract that will or may be settled in the entity’s own equity instruments and is:

?????i.??a non-derivative contract for which the entity is or may be obliged to deliver a variable number of its own equity instruments (e.g. an instrument that is redeemable in own shares to the value of the carrying amount of the instrument); or

????ii.??a derivative contract over own equity 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 (e.g. a net-share settled written call over own shares).

As per the guidance available in Ind AS 109 Financial Instruments relating to initial recognition, subsequent measurement, and derecognition:

A.?????Initial recognition:

An entity shall recognize a borrowing from a bank as a financial liability in its balance sheet when, and only when, the entity becomes a party to the contractual provision of the instrument. Accordingly, borrowing from a bank is a contractual obligation between the lending bank and the borrower.

Borrowings from a bank should be initially recognized at fair value and would be classified at Amortized Cost using the effective interest rate method. (Further guidance in Analysis of Query II).

B.?????Subsequent Measurement:

Long-term Borrowings would be subsequently measured at amortized cost. The entity would be required to calculate the amortized cost using the effective interest rate method for each long-term Borrowings and recognize the interest cost in the statement of profit and loss.

It shall continue to provide for interest cost on the general principle of the financial reporting framework, i.e., the accrual concept of accounting even if the entity has not made the payment of the principal or interest.

C.?????Derecognition:

Borrowings should be derecognized when and only when, it is extinguished—i.e., when the obligation specified in the contract is discharged or canceled or expires as per Para 3.3.1.

Further, para 3.3.2, “An exchange between an existing borrower and lender of debt instruments with substantially different terms shall be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.”

Conclusion:

A plain vanilla debt instrument is a financial liability but crucial to get back to our accounting roots to understand that the interest on such debt instruments which is accrued and not paid is also a liability. Accordingly, the above analysis clarifies that interest cost payable is also a contractual obligation to be settled in cash and is required to be recognized as a financial liability only, as its classification shall remain at amortized cost only and shall be presented as a current liability.?????????????

With the classification as a current liability and at amortized cost, there will not be any further requirement to measure it using an effective interest rate (based on the understanding of the principles and guidance).

If an entity is not able to make payments towards the principal or interest on its debt instruments, RBI guidelines are present and applicable to banks for the classification of such a loan asset in the books of Lending banks as a non-performing asset (NPA). RBI guidelines do not apply to the borrowers of the debt instrument and accordingly do not permit them to derecognize the financial liability towards principal and interest. The classification of a loan asset in the books of a bank as NPA is merely to understand the financial position, liquidity, and assessment of credit risk of the banks and does not form the basis of accounting treatment in the books of the borrower.

As per the application guidance of Ind AS 109, para B3.3.1, “A financial liability (or part of it) is extinguished when the debtor either:

a)?????discharges the liability (or part of it) by paying the creditor, normally with cash, other financial assets, goods, or services; or

b)?????is legally released from primary responsibility for the liability (or part of it) either by process of law or by the creditor. (If the debtor has given a guarantee this condition may still be met.)”

Accordingly, the principal and interest being unpaid in the given case shall not be derecognized unless the lending bank has legally released the primary responsibility of liability by a mutual settlement/one-time settlement is completed legally. The mere consideration of the negotiation process towards a one-time settlement will not be considered as any grounds for discontinuance of recognizing interest cost on such debt instrument on an accrual basis.

The process of negotiation for one-time settlement shall be considered as a basis for modification of terms of the debt contract by both parties and accordingly, the entity in that case on completion of the negotiation process shall derecognize the original liabilities towards the principal and interest and recognize the new financial liabilities based on negotiated terms, and accordingly legally liable to settle it.

Practical insight:

Ind AS are principle driven accounting framework rather than a rule-based accounting framework which provides the flexibility to the entities to resort to mold the principles to their own benefit and may intentionally try to draw inappropriate basis for justification of incorrect accounting. A clear understanding of the intention of discontinuance of recognition of interest cost will only help the entity to negotiate with the lending bank stating that the auditors have even agreed upon the derecognition of financial liabilities from their book and accordingly, save monies towards the final settlement towards original liability.

Professionals are advised to exercise due care towards recognition, discontinuance, or derecognition of liabilities and must follow the principles while exercising professional judgment and practical experiences.

Disclaimer:

Please do not consider this document as an advisory or conclusive note for the basis of accounting treatments to be done, it is more pertinent to understand the individual situation and apply the principles of the financial reporting framework on a case-to-case basis rather than sticking to a piece of advice available online. I do hereby absolve myself from any conclusion drawn without proper professional care and use of judgments of the situation in hand without any informed and practical decision-making based upon the knowledge of Ind AS or IFRS.

Contact:

Vishal Kulthia

Chartered Accountant and Certified IPSAS professional

Email id: [email protected]

Contact no: +91 9830797401