Financial instruments encompass a wide variety of arrangements and contracts that are fundamental to business transactions and corporate finance. Items such as debtors, cash, loans and advances, share capital, debentures, borrowings, trade payables, and derivatives are common examples. These items require proper accounting and reporting to ensure transparency, comparability, and compliance with financial reporting standards.
For entities preparing their financial statements in accordance with Indian Accounting Standards, the primary guidance for financial instruments is contained in Ind AS 109 – Financial Instruments. This standard has a wide-ranging scope and applies to almost all types of financial assets and financial liabilities. It covers the recognition and derecognition of financial assets and liabilities, the classification principles that determine their accounting treatment, the measurement basis for different categories, and the framework for hedge accounting.
In addition to Ind AS 109, two other standards form part of the financial instrument reporting framework. Ind AS 32, Financial Instruments: Presentation, deals with the classification of instruments as either liabilities or equity and sets out the conditions under which financial instruments may be offset in the statement of financial position. Ind AS 107, Financial Instruments: Disclosures, specifies the requirements for disclosures to enable users of financial statements to understand the significance of financial instruments to the entity and the nature and extent of risks arising from them.
When applied together, Ind AS 32, Ind AS 109, and Ind AS 107 create a comprehensive framework for the recognition, measurement, presentation, and disclosure of financial instruments, promoting uniformity and improving the quality of financial reporting.
What is a Financial Instrument
A financial instrument is defined as any contract that gives rise to both a financial asset for one entity and a financial liability or an equity instrument for another entity. This definition highlights the fact that a single arrangement can simultaneously represent a resource to one party and an obligation or ownership interest to another.
For an arrangement to qualify as a financial instrument, it must involve at least two parties to the contract, and it must create enforceable rights and obligations. A contract can be written or oral, but it must be enforceable by law in order to fall within the scope of the standards. This enforceability is important because it ensures that the rights and obligations arising from the contract can be upheld in a legal setting.
Financial instruments range from simple instruments such as cash and trade receivables to complex derivatives and structured arrangements. The key commonality is the contractual nature of the rights and obligations they create.
Contract and Contractual Rights
The concept of a contract is central to understanding financial instruments. In the context of the standards, a contract is an agreement between two or more parties that establishes specific rights and obligations, usually enforceable by law. These agreements can be in writing, which is the most common form, or oral, provided they meet the legal requirements for enforceability in the relevant jurisdiction.
Contractual rights may involve the right to receive cash, the right to receive another financial asset, or the right to exchange financial assets or liabilities under conditions that are favourable to the holder. The counterpart to these rights is contractual obligations, which give rise to financial liabilities.
Financial Assets
According to Ind AS 32, a financial asset is any asset that falls into one of several specific categories. Each of these categories has unique features and implications for measurement and presentation.
Cash
Cash is the most liquid and fundamental form of financial asset. It is recognised as a financial asset because it serves as the medium of exchange for transactions and the basis for measuring all other transactions in financial reporting. A deposit of cash with a bank or a similar financial institution is also a financial asset because it represents the contractual right of the depositor to obtain cash from the bank. The ability to convert this deposit into cash on demand or after a short notice period supports its classification as a financial asset.
Equity Instrument of Another Entity
An equity instrument of another entity is an instrument that represents an ownership interest in that entity. This includes investments in equity shares or similar instruments that convey a right to share in the residual profits of the issuing entity. The definition covers more than just equity share capital; it includes any contractual arrangement that conveys such an ownership interest.
These instruments may be acquired for long-term strategic purposes, to gain influence or control over the investee, or for trading purposes. Under Ind AS 109, investments in equity instruments are generally measured at fair value, with changes recognised either through profit or loss or through other comprehensive income, depending on the business model and the entity’s election at initial recognition.
Contractual Right to Receive Cash or Another Financial Asset
Many financial assets arise from a contractual right to receive cash or another financial asset from another entity. Examples include trade receivables, bills receivable, and loans and advances given. These rights typically arise in the course of an entity’s normal business operations when it delivers goods or services to customers or provides funds to other entities.
The measurement of such assets under Ind AS 109 depends on both the nature of the cash flows and the business model under which they are held. If the asset’s contractual cash flows are solely payments of principal and interest and it is held to collect those cash flows, it is measured at amortised cost. If the business model includes both collecting cash flows and selling the asset, it may be measured at fair value through other comprehensive income. Assets held for trading or with cash flows that do not meet the principal-and-interest test are measured at fair value through profit or loss.
Contractual Right to Exchange Financial Assets or Liabilities Under Favourable Conditions
A financial asset can also arise from a contractual right to exchange financial assets or financial liabilities with another entity under conditions that are favourable to the holder. For example, an entity that holds a call option to purchase shares at a price lower than their market value at the time of exercise has a contractual right that is potentially favourable. If the market value exceeds the exercise price, the option is “in the money” and has intrinsic value. The holder recognises this value as a financial asset, while the counterparty recognises a financial liability.
Such derivative instruments are generally measured at fair value through profit or loss, with changes in value reflecting market movements in the underlying variable, whether it be a share price, interest rate, exchange rate, or commodity price.
Contracts Settled in the Entity’s Own Equity Instruments
Some contracts may be settled in the entity’s own equity instruments. A contract is treated as a financial asset if it is a non-derivative under which the entity is or may be obliged to receive a variable number of its own equity instruments, or a derivative that will or may be settled otherwise 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.
In India, the Companies Act, 2013 generally prohibits companies from holding their own shares, except under specific conditions for buy-back. This means such arrangements are rare in the Indian context. In other jurisdictions, however, companies may hold treasury shares, and the accounting treatment reflects this difference in legal framework.
Importance of Classification of Financial Assets
The accurate classification of a financial asset is essential as it influences its measurement, the recognition of income or expense, and the related disclosures in the financial statements. The classification determines whether changes in value are recognised in profit or loss or in other comprehensive income, and whether the asset is measured at amortised cost or fair value.
The approach under Ind AS 109 requires consideration of both the contractual cash flow characteristics of the asset and the business model within which it is held. This dual assessment ensures that the accounting treatment reflects the economic substance of the arrangement and the entity’s intentions for managing the asset.
Risks Associated with Financial Assets
Financial assets carry various types of risk that need to be managed and disclosed. Credit risk is the risk of loss arising from a counterparty’s failure to meet its obligations. Liquidity risk is the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities when they fall due, which can also impact the management of financial assets. Market risk includes interest rate risk, currency risk, and other price risks, all of which can affect the value of financial assets.
Under Ind AS 107, entities are required to provide both qualitative and quantitative disclosures about these risks, the entity’s exposure to them, and the strategies for managing them. This enables users of financial statements to better understand the nature and extent of the risks associated with the entity’s financial assets.
Interaction Between Financial Assets and Other Elements
Financial assets are often directly linked to financial liabilities and equity instruments through the contracts that create them. A loan receivable for one entity is a loan payable for another. An equity investment for one entity is an equity instrument issued by another. These relationships mean that understanding financial assets cannot be separated from understanding financial liabilities and equity instruments.
The classification and measurement of financial assets also affect other areas of financial reporting. For example, impairment requirements under Ind AS 109 apply to financial assets measured at amortised cost and at fair value through other comprehensive income, requiring entities to recognise expected credit losses based on forward-looking information. The presentation of these assets in the financial statements must also align with the requirements of Ind AS 1, which governs the overall presentation of financial statements.
Classification of Financial Assets under Ind AS 109
Ind AS 109 provides a detailed framework for the classification of financial assets, based on both the business model for managing them and their contractual cash flow characteristics. This classification directly impacts how the assets are measured in the financial statements. The standard sets out three primary categories for the classification and subsequent measurement of financial assets: amortised cost, fair value through other comprehensive income, and fair value through profit or loss.
The business model refers to how an entity manages its financial assets in order to generate cash flows, either by collecting contractual cash flows, by selling the assets, or by a combination of both. This is assessed at a higher level of aggregation, reflecting how key management personnel monitor the performance of the portfolio.
The contractual cash flow characteristics test requires that 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. This is commonly referred to as the SPPI test. If the asset passes the SPPI test and is held within a business model whose objective is to collect contractual cash flows, it is measured at amortised cost. If the asset is held in a business model with both objectives of collecting contractual cash flows and selling financial assets, it is measured at fair value through other comprehensive income. Assets that fail the SPPI test or do not fit into these models are measured at fair value through profit or loss.
Classification of Financial Liabilities under Ind AS 109
The classification of financial liabilities is relatively simpler compared to financial assets. Most financial liabilities are measured at amortised cost. However, there are certain exceptions, such as financial liabilities held for trading, derivatives, and those designated at fair value through profit or loss. Liabilities measured at fair value through profit or loss are those where such designation eliminates or significantly reduces an accounting mismatch, or the liability is part of a group of financial instruments managed and evaluated on a fair value basis.
Another important consideration is the treatment of changes in the fair value of financial liabilities designated at fair value through profit or loss. The changes attributable to the entity’s own credit risk are presented in other comprehensive income, unless such presentation creates or enlarges an accounting mismatch in profit or loss. All other changes in fair value are recognised in profit or loss.
Recognition of Financial Instruments
The recognition principle in Ind AS 109 states that an entity shall recognise a financial asset or financial liability in its balance sheet when it becomes a party to the contractual provisions of the instrument. This recognition occurs at the trade date for regular way purchases and sales of financial assets, which is the date on which the entity commits to purchase or sell the asset.
For financial assets, derecognition occurs when the contractual rights to the cash flows from the asset expire, or when the entity transfers the asset and substantially all the risks and rewards of ownership. For financial liabilities, derecognition happens when the obligation specified in the contract is discharged, cancelled, or expires.
Measurement at Initial Recognition
At initial recognition, all financial assets and liabilities are measured at fair value. For instruments not classified at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or liability are added to or deducted from the fair value. For instruments classified at fair value through profit or loss, such transaction costs are expensed immediately in profit or loss.
The fair value at initial recognition is usually the transaction price, which is the fair value of the consideration given or received. However, in certain cases, such as related party transactions or when the transaction is not at market terms, further analysis is needed to ensure that the initial measurement reflects fair value.
Subsequent Measurement of Financial Assets
Once recognised, the subsequent measurement of financial assets depends on their classification. For assets measured at amortised cost, the effective interest method is used to allocate interest income over the relevant period. This method calculates the amortised cost of the asset and allocates interest income using the effective interest rate, which is the rate that exactly discounts the estimated future cash flows to the net carrying amount at initial recognition.
For assets measured at fair value through other comprehensive income, interest income is recognised using the effective interest method, and the asset is remeasured to fair value at each reporting date. The resulting changes in fair value are recognised in other comprehensive income, except for impairment losses and foreign exchange gains and losses, which are recognised in profit or loss. On derecognition, the cumulative gain or loss recognised in other comprehensive income is reclassified to profit or loss.
For assets measured at fair value through profit or loss, all changes in fair value are recognised in profit or loss as they occur, along with any interest or dividend income.
Subsequent Measurement of Financial Liabilities
Most financial liabilities continue to be measured at amortised cost after initial recognition, using the effective interest method to allocate interest expense over the relevant period. Liabilities measured at fair value through profit or loss are measured at fair value at each reporting date, with changes recognised in profit or loss, except for the portion attributable to changes in the entity’s own credit risk, which may be recognised in other comprehensive income.
Special rules apply to financial guarantee contracts and loan commitments issued at below-market interest rates. Financial guarantee contracts are initially recognised at fair value and subsequently measured at the higher of the amount determined under the expected credit loss model and the amount initially recognised less cumulative income recognised.
Impairment of Financial Assets
One of the significant changes brought by Ind AS 109 compared to previous standards is the introduction of the expected credit loss (ECL) model for impairment of financial assets. This model requires entities to recognise impairment losses based on forward-looking information, even if no actual credit loss event has occurred yet.
The ECL model applies to financial assets measured at amortised cost, debt instruments measured at fair value through other comprehensive income, lease receivables, contract assets, and certain loan commitments and financial guarantee contracts.
The standard prescribes a three-stage approach to impairment:
- Stage 1: When the asset is first recognised and credit risk has not increased significantly since initial recognition, an entity recognises a loss allowance based on 12-month expected credit losses.
- Stage 2: If credit risk increases significantly but the asset is not credit-impaired, the loss allowance is measured at lifetime expected credit losses.
- Stage 3: For credit-impaired assets, lifetime expected credit losses are recognised, and interest revenue is calculated on the net carrying amount.
This model ensures earlier recognition of credit losses and requires entities to incorporate historical, current, and forward-looking information in measuring ECL.
Hedge Accounting under Ind AS 109
Hedge accounting is a technique that modifies the normal basis for recognising gains and losses on associated hedging instruments and hedged items, so that both are recognised in profit or loss in the same accounting period. This reduces the volatility that arises in profit or loss when hedging instruments are measured at fair value but the hedged items are measured at cost or another basis.
Ind AS 109 introduces a more principles-based approach to hedge accounting, aligning the accounting more closely with risk management activities. There are three types of hedging relationships recognised:
- Fair value hedge: A hedge of the exposure to changes in the fair value of a recognised asset or liability, or an unrecognised firm commitment.
- Cash flow hedge: A hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction.
- Hedge of a net investment in a foreign operation.
Hedge effectiveness must be demonstrated at inception and on an ongoing basis, and the hedging relationship must be documented. The results of hedge accounting depend on the type of hedge and the effectiveness of the hedge.
Presentation of Financial Instruments under Ind AS 32
Ind AS 32 addresses the classification of financial instruments from the perspective of the issuer, distinguishing between liabilities and equity instruments. The substance of the contractual arrangement, rather than its legal form, determines the classification.
An instrument is classified as a financial liability if the issuer has a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or liabilities under unfavourable conditions. An instrument is classified as equity if it evidences a residual interest in the assets of the entity after deducting all liabilities, and there is no contractual obligation to deliver cash or another financial asset.
Ind AS 32 also covers compound instruments, which contain both a liability and an equity component, such as convertible bonds. These are split into their components on initial recognition, with the liability component measured at fair value and the equity component representing the residual amount.
Offsetting Financial Assets and Liabilities
Offsetting, or netting, refers to presenting a financial asset and a financial liability in the balance sheet as a single net amount. Ind AS 32 permits offsetting only when an entity has a legally enforceable right to set off the recognised amounts, and intends either to settle on a net basis or to realise the asset and settle the liability simultaneously.
The right of set-off must not be contingent on a future event and must be legally enforceable in the normal course of business, in the event of default, and in the event of insolvency or bankruptcy of the entity and all counterparties.
Presentation Requirements under Ind AS 32
Ind AS 32 prescribes the principles for presenting financial instruments as either financial liabilities or equity. The classification is based on the substance of the contractual arrangement rather than the legal form. This approach ensures that the presentation reflects the economic reality of the instrument.
Distinction between Liability and Equity
The key principle in distinguishing liabilities from equity is the presence or absence of a contractual obligation to deliver cash or another financial asset. If such an obligation exists, the instrument is classified as a financial liability. If no such obligation exists and the holder has a residual interest in the entity’s assets after deducting liabilities, the instrument is classified as equity.
Compound Financial Instruments
Some instruments contain both liability and equity components. An example is a convertible bond that grants the holder the right to convert the bond into a fixed number of shares of the issuer. In such cases, Ind AS 32 requires the instrument to be split into its liability and equity components at the time of initial recognition.
Offsetting of Financial Assets and Liabilities
Financial assets and liabilities may be presented on a net basis only when there is a legally enforceable right to set off and the intention to settle on a net basis or to realize the asset and settle the liability simultaneously. This ensures clarity in financial reporting by avoiding misleading representations of gross amounts when net settlement is intended.
Measurement Principles under Ind AS 109
Ind AS 109 specifies how financial assets and liabilities are to be measured after initial recognition. The measurement basis depends on the classification of the financial instrument.
Initial Measurement
At initial recognition, financial assets and liabilities are measured at fair value. For financial assets or liabilities not measured at fair value through profit or loss, transaction costs directly attributable to the acquisition or issue of the instrument are added to or deducted from the fair value.
Subsequent Measurement of Financial Assets
The classification of financial assets for subsequent measurement under Ind AS 109 depends on the entity’s business model for managing the assets and the contractual cash flow characteristics.
- Amortised Cost – Financial assets are measured at amortised cost if they are held within a business model whose objective is to hold assets to collect contractual cash flows and the cash flows are solely payments of principal and interest.
- Fair Value through Other Comprehensive Income (FVOCI) – This category applies if assets are held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, and the cash flows are solely payments of principal and interest.
- Fair Value through Profit or Loss (FVTPL) – All other financial assets are measured at fair value with changes recognized in profit or loss.
Subsequent Measurement of Financial Liabilities
Most financial liabilities are measured at amortised cost using the effective interest method. However, certain liabilities are measured at fair value through profit or loss, particularly those held for trading or designated at fair value upon initial recognition.
Effective Interest Method
The effective interest method is used to calculate the amortised cost of a financial asset or liability and to allocate interest income or expense over the relevant period. This method ensures a constant rate of return over the instrument’s life.
Impairment of Financial Assets
Ind AS 109 introduces an expected credit loss (ECL) model for the impairment of financial assets. This model requires entities to account for expected losses from the time the financial asset is recognized.
Stages of the ECL Model
The ECL approach operates in three stages:
- Stage 1 – At initial recognition, a 12-month ECL is recognized.
- Stage 2 – If credit risk increases significantly, lifetime ECLs are recognized.
- Stage 3 – For credit-impaired assets, lifetime ECLs continue to be recognized, with interest revenue calculated on the net carrying amount.
Simplified Approach
For trade receivables, contract assets, and lease receivables, a simplified approach is permitted. This approach requires the recognition of lifetime ECLs without tracking changes in credit risk.
Hedge Accounting under Ind AS 109
Hedge accounting is designed to align the accounting treatment of a hedging instrument and its hedged item. This minimizes volatility in profit or loss caused by fluctuations in the fair value of the hedging instrument.
Types of Hedges
- Fair Value Hedge – Hedges exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment.
- Cash Flow Hedge – Hedges exposure to variability in cash flows attributable to a particular risk associated with a recognized asset, liability, or forecast transaction.
- Net Investment Hedge – Hedges exposure to foreign currency risk on a net investment in a foreign operation.
Hedge Effectiveness
Ind AS 109 requires that hedging relationships meet certain effectiveness criteria, ensuring that the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows.
Disclosure Requirements under Ind AS 107
Ind AS 107 mandates disclosures to enable users of financial statements to evaluate the significance of financial instruments and the nature and extent of risks arising from them.
Significance of Financial Instruments
Entities must disclose information about the carrying amounts of each category of financial instrument, their fair values, and the methods and assumptions used to estimate fair values.
Risk Disclosures
Entities must disclose qualitative and quantitative information about exposure to risks from financial instruments, including credit risk, liquidity risk, and market risk. This involves providing sensitivity analyses and information about risk management strategies.
Hedge Accounting Disclosures
Where hedge accounting is applied, entities must disclose information about the hedging instruments, hedged items, risk management objectives, and the impact on financial statements.
Interaction between Ind AS 32, Ind AS 109, and Ind AS 107
The three standards work together to ensure consistent and comprehensive reporting of financial instruments.
- Ind AS 32 focuses on classification and presentation.
- Ind AS 109 addresses recognition, measurement, impairment, and hedge accounting.
- Ind AS 107 deals with disclosure requirements.
An entity applying these standards will provide stakeholders with clear, relevant, and reliable information about financial instruments, supporting informed decision-making.
Conclusion
The accounting treatment of financial instruments under Ind AS 32, Ind AS 109, and Ind AS 107 requires a thorough understanding of recognition, measurement, presentation, and disclosure requirements. These standards work together to ensure that entities present a true and fair view of their financial position by appropriately classifying instruments as financial assets, financial liabilities, or equity instruments. The key lies in analyzing the substance of contractual terms rather than relying solely on the instrument’s legal form or title.
Proper classification has far-reaching implications for an entity’s reported financial performance and position, influencing ratios, investor perception, and compliance with legal and regulatory requirements. Likewise, measurement principles, whether at amortized cost or fair value, and the application of hedge accounting can significantly impact the volatility of reported earnings. The detailed disclosure requirements under Ind AS 107 play a vital role in enhancing transparency, enabling stakeholders to understand the nature, extent, and management of financial risks associated with these instruments.
By consistently applying these standards, entities can improve comparability, reliability, and relevance in their financial reporting. Ultimately, the framework provided by these three standards strengthens the integrity of financial statements, supports informed decision-making by users, and fosters greater confidence in the capital markets. In an environment where financial instruments are increasingly complex, the correct application of these principles ensures that financial reporting remains robust, consistent, and aligned with global best practices.