Payment of Interest only if Company makes Profits

Facts of the case:
A holding company has made investment in 8% non-convertible debentures in subsidiary company redeemable within 10 years. Interest is accrued and be payable when subsidiary makes profit. Presently subsidiary makes losses and it expects to make profits from year 2022. If subsidiary does not make profit, no interest is payable. When subsidiary starts making profits, it will have to calculate interest from the date of debenture subscription.

Issue/Query:
Is it mandatory for the subsidiary company to recognise interest expense from day one even though subsidiary has estimated to turn profitable from year 2022 and interest is not accrued till date as per the terms of investment or should it calculate and recognise interest from year 2022 and spread the EIR on remaining life of debenture instrument?

Response:
It is mandatory for subsidiary company to recognise interest expense from day one even though subsidiary has estimated to turn profitable from year 2022.

Basis for Response:
1. In accordance with paragraph 5.3.1 read with 4.2.1 of Ind AS 109 Financial Instruments, the 8% non-convertible debentures issued by the subsidiary shall be measured at amortised cost.

2. Appendix A of Ind AS 109 defines Amortised cost of a financial asset or a financial liability as under:
“The amount at which the financial asset or financial liability is measured at initial recognition minus the 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, for financial assets, adjusted for any loss allowance.”

3. Appendix A of Ind AS 109 defines effective interest method as under:
“The method that is used in the calculation of the amortised cost of a financial asset or a financial liability and in the allocation and recognition of the interest revenue or interest expense in profit or loss over the relevant period.”

4. Appendix of Ind AS 09 defines effective interest rate as under:
“The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider expected credit losses…”

5. The subsidiary company expects to turn profitable in the year 2022. The querist has submitted that when subsidiary starts making profits, it will have to calculate interest from the date of debenture subscription. The company shall calculate the effective interest rate of the instrument considering the expected cash flows comprising of interest cash flows from the year 2022 which will include interest calculated from the date of debenture subscription and principal cash flows at the end of the term of the debentures. The company shall recognise interest expense at effective interest rate so calculated on effective interest method from initial recognition of the non-convertible debentures to measure the non-convertible debenture at amortised cost. The recognition of interest expense from the year when the subsidiary turns profitable or the year when actual interest cash flows happen is not in accordance with Ind AS 109.