QUESTION 5 Illustration 5: Contract for exchange on unfavorable conditions A Limited (the ‘Company’) makes a borrowing for INR 10 Lakhs from RBC Bank, with bullet repayment of INR 10 Lakhs and an annual interest rate of 12% per annum. Now, Company defaults at the end of 5th year and consequently, a rescheduling of the payment schedule is made beginning 6th year onwards. The Company is required to pay INR 1,300,000 at the end of 6th year for one time settlement, in lieu of defaults in payments made earlier. a) Does the above instrument meet definition of financial liability? Please explain. b) Analyze the differential amount to be exchanged for one-time settlement
Solution
a) A Limited has entered into an arrangement wherein against the borrowing, A Limited has contractual obligation to make stream of payments (including interest and principal). This meets definition of financial liability.
b) Let’s compute the amount required to be settled and any differential arising upon one time settlement at the end of 6th year –
♦ Loan principal amount = $ 10,00,000
♦ Amount payable at the end of 6th year = $ 12,54,400 [10,00,000 * 1.12 * 1.12 (Interest for 5th & 6th year in default plus principal amount)]
♦ One-time settlement = INR 13,00,000
♦ Additional amount payable = $ 45,600
The above represents a contractual obligation to pay cash against settlement of a financial liability under conditions that are unfavorable to A Limited (owing to additional amount payable in comparison to amount that would have been paid without one time settlement). Hence, the rescheduled arrangement meets definition of ‘financial liability’.
a) Yes, the above instrument meets the definition of financial liability as per IAS 32. It involves a contractual obligation to deliver cash or another financial asset to another entity, which is the RBC Bank in this case. The borrowing of INR 10 lakhs is a liability for the company, and the annual interest rate of 12% per annum is the cost of borrowing. The rescheduling of the payment schedule also involves a contractual obligation to deliver cash to the RBC Bank, which makes it a financial liability.
b) The differential amount to be exchanged for one-time settlement would be the present value of the remaining payments at the market rate of interest at the date of settlement, less the one-time settlement amount of INR 1,300,000.
To calculate the present value of the remaining payments, we need to determine the cash flows and the market rate of interest. The cash flows for the remaining payments would be INR 10,00,000 at the end of the 7th year, plus the interest payments for the 6th and 7th years. The interest payments for the 6th and 7th years would be calculated as follows:
Interest payment for 6th year = INR 10,00,000 x 12% = INR 1,20,000
Interest payment for 7th year = (INR 10,00,000 + INR 1,20,000) x 12% = INR 1,44,400
Therefore, the cash flows for the remaining payments would be INR 1,20,000 for the 6th year, INR 1,44,400 for the 7th year, and INR 10,00,000 for the bullet repayment at the end of the 7th year.
Assuming that the market rate of interest at the date of settlement is 10% per annum, the present value of the remaining payments would be calculated as follows:
Present value of INR 10,00,000 = INR 10,00,000 / (1 + 10%)^2 = INR 8,264
Present value of INR 1,20,000 = INR 1,20,000 / (1 + 10%) = INR 1,09,091
Present value of INR 1,44,400 = INR 1,44,400 / (1 + 10%)^2 = INR 1,13,631
Therefore, the present value of the remaining payments would be INR 10,00,000 + INR 1,20,000 + INR 1,44,400 = INR 12,64,400.
The differential amount to be exchanged for one-time settlement would be INR 12,64,400 - INR 13,00,000 = INR -35,600, which means that the company would receive INR 35,600 less than the present value of the remaining payments at the market rate of interest.
