Classification of Investment in Non-convertible Debenture
Facts of the case:
A Holding Company has invested in 9% non-convertible debentures redeemable within 10 years. As per the terms of the investment agreement, interest will accrue and be payable when subsidiary company makes profit. Presently, subsidiary is making losses and estimated to make profit from year 2022. Once subsidiary starts making profit, it must pass interest expense entry from the date of debenture subscription made by the holding company.
Issue/Query:
Is it mandatory for the holding company to recognise interest income from day one even though it is not certain about its realisation or should it wait till subsidiary makes profit?
Response:
1. The holding company shall measure investment in non-convertible debentures at fair value through profit or loss
2. The holding company shall recognise in profit or loss changes in fair value of the instrument and not interest income on effective interest method.
3. While disclosing fair value changes, the company may disclose separately interest receipts and other fair value changes.
4. The holding company shall disclose in its accounting policies whether fair value gains / losses in profit or loss includes interest income.
Basis for Response:
1. Paragraph 5.2.1 of Ind AS 109 Financial Instruments states as under:
“After initial recognition, an entity shall measure a financial asset in accordance with paragraphs 4.1.1-4.1.5 at:
a. Amortised cost;
b. Fair value through other comprehensive income; or
c. Fair value through profit or loss”
2. Paragraphs 4.1.1-4.1.5 of Ind AS 109 states as under:
“4.1.1 Unless paragraphs 4.1.5 applies, an entity shall classify financial assets as subsequently measured at amortised cost, fair value through other comprehensive income or fair value through profit or loss on the basis of both:
a. The entity’s business model for managing the financial assets and
b. The contractual cash flow characteristics of the financial asset.
4.1.2 A financial asset shall be measured at amortised cost if both of the following conditions are met:
a. the financial asset is held within a business model whose objective is to hold financial assets in order to collect contractual cash flows; and
b. the contractual cash flows of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Paragraphs B4.1.1-B4.1.26 provide guidance on how to apply these conditions.
4.1.2A A financial asset shall be measured at fair value through other comprehensive income if both of the following conditions are met:
a. the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets and
b. the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Paragraphs B4.1.1-B4.1.26 provide guidance on how to apply these conditions.
4.1.3 For the purpose of applying paragraph 4.1.2(b) and 4.1.2A(b):
a. principal is the fair value of the financial asset at initial recognition. Paragraph B4.1.7B provides additional guidance on the meaning of principal.
b. Interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as a profit margin. Paragraph B4.1.7A and B4.1.9A-B4.1.9E provide additional guidance on the meaning of interest, including the meaning of the time value of money.
4.1.4 A financial asset shall be measured at fair value through profit or loss unless it is measured at amortised cost in accordance with paragraph 4.1.2 or at fair value through other comprehensive income in accordance with paragraph 4.1.2A. However, an entity may make an irrevocable election at initial recognition for particular investments in equity instruments that would otherwise be measured at fair value through profit or loss to present subsequent changes in fair value in other comprehensive income (see paragraphs 5.7.5-5.7.6).
4.1.5 Despite paragraphs 4.1.1-4.1.4, an entity may, at initial recognition, irrevocably designate a financial asset as measured at fair value through profit or loss if doing so eliminates or significantly reduces a measurement or recognition inconsistency (referred to as an ‘accounting mismatch’) that would otherwise arise from measuring assets or liabilities or recognising the gains and losses on them on different bases. (see paragraphs B4.1.29-B4.1.32).”
3. Interest on 9% non-convertible debentures is payable when the subsidiary company makes profit. The holding company expects the subsidiary to make profit from year 2022. However, the querist has not submitted details on whether any amount (interest and/ or principal) will be paid if the subsidiary does not make profit in the entire term of debentures. Thus, the contractual cash flows do not reflect a return that is consistent with a basic lending agreement. The payments in the contract depend on the financial performance of the subsidiary. Therefore, the contractual terms of the 9% non-convertible debentures do not give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding. Accordingly, the 9% non-convertible debentures will be measured at fair value through profit or loss.
4. Paragraph B5 of Ind AS 107 Financial Instruments: Disclosures requires disclosure of 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. The company shall disclose its policy of presentation of interest receipts on non-convertible debentures classified as subsequently measured at fair value through profit or loss in its material accounting policy information.