In the domain of financial reporting, one of the most vital and comprehensive topics is the treatment of financial instruments. Financial instruments form the basis of numerous transactions and are integral to the structure of financial statements. Understanding their classification, measurement, and presentation is key for accountants, auditors, and analysts alike.
Indian Accounting Standards have dedicated three detailed standards to deal with financial instruments. These are Ind AS 109, Ind AS 32, and Ind AS 107. Each of these standards plays a unique and complementary role in ensuring that financial instruments are accounted for and reported consistently.
When dealing with components such as debtors, cash, loans and advances, share capital, debentures, loans taken, trade payables, and derivatives, it is Ind AS 109 that governs their accounting treatment. This standard has an extensive scope and touches upon almost every element of the balance sheet involving financial instruments.
Overview of the Three Key Standards
Ind AS 109 – Financial Instruments
Ind AS 109 primarily focuses on the recognition and derecognition of financial assets and liabilities. It also deals with their classification and measurement. One of the advanced areas covered under this standard is hedge accounting, which allows for the alignment of accounting outcomes with an entity’s risk management activities.
Ind AS 32 – Financial Instruments: Presentation
Ind AS 32 addresses the classification of financial instruments, particularly whether they should be presented as financial liabilities or equity instruments. This standard also provides rules on the offsetting or netting of financial assets and liabilities.
Ind AS 107 – Financial Instruments: Disclosures
Ind AS 107 complements the above two by laying down disclosure requirements. These disclosures provide users of financial statements with meaningful insights into the significance of financial instruments and the risks associated with them.
Defining a Financial Instrument
A financial instrument is defined as any contract that results in a financial asset for one entity and a financial liability or equity instrument for another entity. This definition implies the presence of two parties to a contract, where the economic rights and obligations are clearly delineated.
The term contractual in this context refers to a legally binding agreement between two or more parties. Such agreements are enforceable by law and can be either written or verbal, as long as the essential elements of a contract are satisfied.
Understanding Financial Assets
According to Ind AS 32, a financial asset is any asset that falls into one of the following categories:
Cash
Cash is universally accepted as a financial asset because it is the medium through which transactions are executed. It serves as the basic unit of measure in accounting and financial reporting.
Equity Instrument of Another Entity
When an entity holds equity instruments such as shares of another company, it possesses a financial asset. This is because the investment represents a claim on the residual interest of another entity.
Contractual Right to Receive Cash or Another Financial Asset
This includes assets such as trade receivables, bills receivable, and loans and advances given. These represent contractual rights to receive cash, and therefore, qualify as financial assets under Ind AS 32.
Contractual Right to Exchange Financial Instruments under Favourable Conditions
Sometimes, financial assets arise from contracts that allow one party to exchange financial instruments under conditions that are favorable. A practical example is a call option that gives the holder the right to buy shares at a price lower than the market rate. The holder benefits from the favorable pricing and thus holds a financial asset.
Contracts Involving Own Equity Instruments
In some scenarios, contracts settled using an entity’s own equity instruments may also result in financial assets. For instance, contracts that require receiving a variable number of own equity shares can be considered financial assets. However, such provisions are generally not applicable in India due to legal restrictions on holding own shares.
Understanding Financial Liabilities
A financial liability, as defined under Ind AS 32, arises in the following circumstances:
Contractual Obligation to Deliver Cash or Another Financial Asset
This is the most common form of financial liability and includes trade payables, borrowings, and loans taken. The defining feature is the obligation to deliver cash or another financial asset to another entity.
Obligation to Exchange Financial Instruments under Unfavourable Conditions
If a contract requires an entity to exchange financial instruments under terms that are not favorable, it creates a financial liability. An example is writing a call option that results in the entity having to deliver shares at a price lower than the market value.
Contracts Involving Own Equity Instruments
Some financial liabilities involve the delivery of own equity instruments. If the contract requires delivering a variable number of own shares, or if it involves a settlement mechanism other than a fixed-for-fixed exchange, it constitutes a financial liability.
Convertible debentures that convert based on the market value of shares are a good example. Since the number of shares issued upon conversion can vary, the instrument is treated as a financial liability.
Distinguishing Equity Instruments
An equity instrument is a contract that represents a residual interest in the assets of an entity after all liabilities have been deducted. Holders of such instruments are entitled to the remaining assets upon liquidation.
Ind AS 32 provides two critical criteria to determine whether an instrument qualifies as equity:
- The instrument should not contain any contractual obligation to deliver cash or another financial asset.
- If it is settled using the issuer’s own equity instruments, the settlement must involve the exchange of a fixed amount of cash or another financial asset for a fixed number of equity instruments.
If either of these conditions is not met, the instrument is not classified as equity. Instead, it may fall under financial liabilities or derivatives depending on its terms.
It is important to understand that the legal form or name of an instrument does not determine its classification. A debenture or preference share might legally be categorized under equity, but if it includes an obligation to pay fixed returns or redeem the principal, it may need to be classified as a liability.
Practical Illustrations and Examples
To reinforce the understanding of these classifications, let us consider a few practical examples:
Trade Receivables
When a company sells goods or services on credit, it creates a trade receivable. This is a financial asset for the seller because there is a contractual right to receive cash.
Loans and Advances Given
If a company provides a loan to another entity, the amount receivable qualifies as a financial asset. The contractual right to receive interest and principal repayment defines its nature.
Share Capital Issued
Equity shares issued by a company represent equity instruments. Shareholders are entitled to residual interests and generally do not have a guaranteed return or redemption obligation.
Convertible Debentures
These instruments can often present a classification challenge. If the number of shares issued upon conversion is variable, based on market price, the instrument is a financial liability. If the conversion ratio is fixed, it may be classified as a compound instrument containing both equity and liability components.
Derivatives
Financial instruments such as forwards, options, and swaps fall under the category of derivatives. Their classification depends on the rights and obligations embedded in the contracts. A derivative that is favorable to the holder is a financial asset, while one that is unfavorable is a financial liability.
Options and Warrants
If an entity issues options or warrants that allow the holder to purchase a fixed number of equity shares for a fixed amount of cash, the instrument is classified as equity. However, if the number of shares or the amount of consideration is variable, the classification changes accordingly.
Treasury Shares
Although not applicable under Indian law, companies in some jurisdictions are permitted to hold their own shares. These are known as treasury shares. Contracts involving such shares are treated differently under the accounting standards applicable in those regions.
Foreign Currency Convertible Bonds
These instruments provide the bondholder with the right to convert bonds into equity shares at a fixed conversion price, even if denominated in a foreign currency. Under Ind AS 32, these are still considered equity instruments if the number of shares and the amount of foreign currency are fixed.
Understanding the correct classification of financial instruments is critical for ensuring the accuracy of financial statements. It also impacts the decision-making of investors, regulators, and management.
Recognition and Measurement of Financial Instruments
Understanding how to recognize and measure financial instruments is essential for preparing reliable and consistent financial statements. Builds upon the foundational knowledge and focuses on the recognition and measurement principles under Ind AS 109. Recognition refers to the process of incorporating a financial instrument into the balance sheet, while measurement relates to determining the monetary amounts at which these instruments are reported.
Initial Recognition of Financial Instruments
According to Ind AS 109, an entity should recognize a financial asset or a financial liability in its balance sheet when, and only when, it becomes a party to the contractual provisions of the instrument. This means that recognition occurs when a legally enforceable contract is in place, even if the physical exchange or transfer of funds has not yet taken place.
For example, if an entity enters into a forward contract to buy or sell foreign currency, the financial instrument is recognized on the date the contract is signed, not when the currency is actually exchanged.
The recognition principle applies to both financial assets and financial liabilities. In some cases, such as regular way purchases or sales of financial assets, Ind AS 109 allows entities to choose between trade date and settlement date accounting. Under trade date accounting, recognition happens when the trade is agreed upon, whereas settlement date accounting records the asset or liability when the actual exchange takes place.
Measurement at Initial Recognition
At the time of initial recognition, financial instruments are measured at fair value. In most cases, fair value equals the transaction price, which is the amount paid or received to acquire or issue the instrument. However, if there is evidence that the fair value differs from the transaction price, the difference must be accounted for separately.
For instance, when a loan is granted at a concessional interest rate, the fair value of the loan might be less than the amount disbursed. The difference between the transaction price and fair value is recognized as an expense or income, depending on the nature of the transaction.
In addition to fair value, transaction costs must be considered at initial recognition. Transaction costs are incremental costs directly attributable to the acquisition or issue of the financial asset or liability. These costs are added to or deducted from the fair value, depending on the classification of the instrument.
Classification of Financial Assets
Ind AS 109 requires financial assets to be classified into one of the following three categories:
Amortized Cost
A financial asset is measured at amortized cost if it meets two conditions:
- The asset is held within a business model whose objective is to hold assets to collect contractual cash flows.
- The contractual terms of the asset give rise to cash flows that are solely payments of principal and interest on specified dates.
Examples include trade receivables, term deposits, and loans granted. These assets are measured using the effective interest rate method, which allocates interest income and any discount or premium over the expected life of the asset.
Fair Value Through Other Comprehensive Income (FVTOCI)
This classification is applicable when:
- The asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets.
- The contractual terms give rise to solely payments of principal and interest.
Under this category, the financial asset is measured at fair value, but the unrealized gains or losses are recognized in other comprehensive income until the asset is derecognized.
Fair Value Through Profit or Loss (FVTPL)
Financial assets that do not meet the criteria for amortized cost or FVTOCI are classified under FVTPL. Changes in fair value are recognized directly in profit or loss.
This category includes trading instruments, derivatives, and other complex financial products. Even debt instruments that fail the solely payments of principal and interest test are measured at FVTPL.
Business Model Assessment
The business model assessment determines how an entity manages its financial assets to generate cash flows. It is based on observable past activities and not merely on management’s intentions.
For example, if an entity primarily holds assets to collect interest and principal but occasionally sells assets to manage credit risk, the business model may still qualify for amortized cost classification. However, frequent and significant sales would suggest a business model aimed at selling, pushing the classification toward FVTOCI or FVTPL.
SPPI Test (Solely Payments of Principal and Interest)
The SPPI test is designed to assess whether the cash flows from the financial asset are consistent with a basic lending arrangement. Principal refers to the fair value of the asset at initial recognition, while interest includes consideration for the time value of money, credit risk, and other basic lending risks.
If a financial asset contains features such as leverage, convertible terms, or performance-linked payments, it fails the SPPI test and must be classified under FVTPL.
Reclassification of Financial Assets
Reclassification is only allowed when an entity changes its business model for managing financial assets. This is expected to be infrequent and must be demonstrable to external parties. The reclassification applies prospectively from the reclassification date and requires the entity to reassess the measurement of the affected assets.
For example, if an entity that previously held assets for collection decides to start actively trading them, the assets must be reclassified from amortized cost to FVTPL or FVTOCI depending on the business model.
Measurement of Financial Liabilities
Financial liabilities are generally measured at amortized cost. However, certain financial liabilities are measured at fair value through profit or loss, such as:
- Derivative liabilities
- Financial liabilities held for trading
- Liabilities designated at fair value through profit or loss to eliminate or reduce an accounting mismatch
Amortized cost is calculated using the effective interest method. This method spreads transaction costs, premiums, and discounts over the expected life of the instrument, resulting in a constant rate of return.
Derecognition of Financial Assets
Derecognition refers to the removal of a financial asset from the balance sheet when:
- The contractual rights to cash flows expire, or
- The asset is transferred and the risks and rewards of ownership are substantially transferred
A transfer may involve selling the asset or entering into arrangements such as factoring. If the entity retains substantial risks and rewards, derecognition is not allowed, and the asset must remain on the balance sheet.
If some risks and rewards are retained but control is lost, the asset is derecognized, and any retained interest is recognized as a separate asset.
Derecognition of Financial Liabilities
A financial liability is derecognized when the obligation is discharged, cancelled, or expires. If an existing liability is replaced with a substantially different liability, or the terms are significantly modified, the original liability is derecognized, and a new liability is recognized.
Significant changes in terms may include changes in interest rate, maturity, or other contractual elements. The difference between the carrying amount of the old liability and the new liability is recognized in profit or loss.
Embedded Derivatives
An embedded derivative is a component of a hybrid instrument that also contains a non-derivative host contract. If the embedded derivative is not closely related to the host and the hybrid instrument is not measured at FVTPL, it must be separated and accounted for as a standalone derivative.
For example, a convertible bond contains an embedded option to convert into equity shares. If the conversion option is not closely related to the bond, it must be accounted for separately.
Impairment of Financial Assets
Ind AS 109 introduces the expected credit loss model for impairment. This model applies to financial assets measured at amortized cost or FVTOCI. The objective is to recognize credit losses earlier than under the previous incurred loss model.
Expected credit losses are recognized in three stages:
- Stage 1: Performing assets with low credit risk. Recognize 12-month expected credit losses.
- Stage 2: Significant increase in credit risk. Recognize lifetime expected credit losses.
- Stage 3: Credit-impaired assets. Recognize lifetime expected credit losses and adjust the interest income using the net carrying amount.
The assessment involves evaluating forward-looking information, historical data, and the borrower’s creditworthiness.
Hedge Accounting
Hedge accounting aligns the accounting for hedging instruments with the risk management activities of an entity. Ind AS 109 allows for the designation of hedging relationships if certain conditions are met.
There are three types of hedging relationships:
- Fair value hedge: Offsets changes in fair value of a recognized asset or liability.
- Cash flow hedge: Offsets variability in cash flows from a recognized asset or liability or a forecast transaction.
- Net investment hedge: Offsets foreign currency risks of a net investment in a foreign operation.
To qualify for hedge accounting, an entity must formally document the relationship, the risk being hedged, and how effectiveness will be assessed. Hedge effectiveness must be within a range of 80 to 125 percent.
Gains and losses from the hedging instrument are recognized based on the type of hedge. In fair value hedges, both the hedging instrument and the hedged item are adjusted for fair value changes. In cash flow hedges, the effective portion is recognized in other comprehensive income and reclassified to profit or loss when the hedged item affects earnings. Hedge accounting requires continuous monitoring and reassessment. If the hedge no longer qualifies, hedge accounting is discontinued prospectively.
Presentation and Disclosures of Financial Instruments
Financial instruments play a crucial role in determining the financial position and performance of an entity. While the recognition and measurement of these instruments are governed by Ind AS 109, the presentation of financial instruments is dealt with under Ind AS 32, and disclosures are guided by Ind AS 107. We explored the rules related to the classification, presentation, and disclosure of financial instruments in the financial statements.
Presentation of Financial Instruments under Ind AS 32
The primary objective of Ind AS 32 is to establish clear principles for presenting financial instruments as either financial liabilities or equity instruments. This standard also provides guidance on when financial assets and liabilities can be offset in the financial statements.
Classification of Financial Instruments
The classification of a financial instrument depends on the substance of the contractual arrangement, rather than its legal form or name. It is essential to assess whether the instrument creates a contractual obligation for the issuer.
If a financial instrument results in a contractual obligation to deliver cash or another financial asset to another party, it must be classified as a financial liability. On the other hand, if the instrument evidences a residual interest in the net assets of the entity after deducting all liabilities, it is classified as an equity instrument.
Equity Instruments
Equity instruments represent ownership interests in an entity. Examples include ordinary shares, certain preference shares, and share warrants. An instrument is considered equity only if it meets both of the following conditions:
- It does not include a contractual obligation to deliver cash or another financial asset.
- If it is settled in the issuer’s own equity instruments, it must involve the exchange of a fixed amount of cash for a fixed number of shares.
Any deviation from the fixed-for-fixed condition will result in the instrument being classified as a financial liability or a compound financial instrument.
Financial Liabilities
Instruments that impose an obligation to repay, redeem, or settle in cash or another financial asset are classified as financial liabilities. This includes instruments such as loans, debentures, trade payables, and redeemable preference shares.
Redeemable preference shares, although legally termed as equity, are classified as liabilities under Ind AS 32 if they carry an obligation to repay the principal or pay dividends at fixed intervals.
Compound Financial Instruments
A compound financial instrument is one that contains both a liability component and an equity component. A common example is a convertible debenture that gives the holder the right to convert it into equity shares of the issuer.
In such cases, the issuer must split the instrument into its liability and equity components at initial recognition. The liability component is measured at fair value using a market rate of interest, and the residual amount is classified as equity.
Treasury Shares
Although Indian law does not permit companies to hold their own shares, some jurisdictions allow for treasury shares. When an entity reacquires its own equity instruments, they are deducted from equity. No gain or loss is recognized in profit or loss on the purchase, sale, issue, or cancellation of treasury shares.
Offsetting Financial Assets and Liabilities
Ind AS 32 provides guidance on when an entity may offset a financial asset and a financial liability in its financial statements. Offsetting is permitted only when:
- The entity currently has a legally enforceable right to set off the recognized amounts.
- The entity intends to settle on a net basis or to realize the asset and settle the liability simultaneously.
This requirement ensures that the financial statements reflect the actual rights and obligations of the entity rather than the gross positions of unrelated assets and liabilities.
Disclosure of Financial Instruments under Ind AS 107
Ind AS 107 lays down the disclosure requirements for financial instruments to ensure that users of financial statements can understand their significance and associated risks. The standard aims to enhance transparency and help stakeholders make informed decisions.
Objectives of Disclosure
The disclosure requirements under Ind AS 107 serve the following key objectives:
- Provide information about the significance of financial instruments in the financial position and performance of an entity.
- Disclose the nature and extent of risks arising from financial instruments, including credit risk, liquidity risk, and market risk.
Categories of Disclosure
Disclosures under Ind AS 107 can be broadly classified into two categories:
- Information on the significance of financial instruments.
- Information on the nature and extent of risks arising from financial instruments.
Significance of Financial Instruments
Entities must disclose details that help users understand the impact of financial instruments on the financial statements. This includes:
- The accounting policies applied to each category of financial instrument.
- Carrying amounts of each category of financial asset and financial liability.
- Details of financial instruments measured at fair value, including the valuation techniques used.
- Information on financial instruments designated at fair value through profit or loss.
For instance, if an entity designates a loan as at fair value through profit or loss, it must disclose the reasons for such designation and the impact on profit or loss.
Statement of Financial Position Disclosures
Disclosures required in the balance sheet include:
- Categories of financial assets and liabilities
- Fair value hierarchy levels
- Details of any reclassifications
- Information on collateral and other credit enhancements
Entities must provide a breakdown of financial instruments based on classification and measurement category. This helps users understand how different financial instruments are treated in the financial statements.
Income Statement and Other Comprehensive Income Disclosures
Entities must disclose the following in the statement of profit or loss and other comprehensive income:
- Total interest income and interest expense
- Fee income and expense
- Gains and losses from derecognition
- Impairment losses or reversals
- Gains or losses from changes in fair value
These disclosures help stakeholders assess the performance of financial instruments and the income streams derived from them.
Risk Disclosures
Ind AS 107 requires extensive disclosures on risks associated with financial instruments. The three main risk categories are:
Credit Risk
Credit risk is the risk of financial loss due to a counterparty’s failure to meet its contractual obligations. Entities must disclose:
- Maximum exposure to credit risk
- Collateral held as security
- Credit quality of financial assets
- Changes in credit risk and credit loss allowances
Liquidity Risk
Liquidity risk arises when an entity is unable to meet its payment obligations. Disclosures include:
- Maturity analysis of financial liabilities
- Policies for managing liquidity risk
- Undrawn borrowing facilities and credit lines
A contractual maturity table should be presented, showing undiscounted cash flows by time buckets, including both on-balance sheet and off-balance sheet obligations.
Market Risk
Market risk refers to the risk arising from changes in market variables such as interest rates, foreign exchange rates, and equity prices. Disclosures should include:
- Sensitivity analysis for each type of market risk
- Methods and assumptions used in preparing the analysis
- Risk management strategies
Entities must describe how they manage market risks, including the use of derivatives and hedging activities.
Fair Value Disclosures
For financial instruments measured at fair value, Ind AS 107 requires disclosure of fair value hierarchy levels:
- Level 1: Quoted prices in active markets
- Level 2: Inputs other than quoted prices that are observable
- Level 3: Unobservable inputs
Entities must disclose transfers between levels, valuation techniques, and inputs used. For Level 3 measurements, a reconciliation of the opening and closing balances must be provided.
Hedge Accounting Disclosures
If an entity applies hedge accounting, it must provide the following:
- Description of the hedging relationship and risk management objective
- Nature of the hedged item and hedging instrument
- Hedge effectiveness and how it is measured
- Amounts recognized in profit or loss and other comprehensive income
These disclosures enable users to understand the impact of hedging activities and how risks are mitigated through financial instruments.
Derecognition Disclosures
When financial assets or liabilities are derecognized, entities must disclose:
- The reasons for derecognition
- Any continuing involvement in the asset
- The risks retained and the nature of the involvement
This is particularly important in cases involving securitizations, transfers, or factoring arrangements where the entity may still bear some risks.
Reclassification Disclosures
If financial assets are reclassified between categories, entities must disclose:
- The date and reason for reclassification
- The amount reclassified
- Changes in fair value previously recognized
Reclassifications must be explained clearly to allow users to understand the business model changes that led to the reclassification.
Collateral and Credit Enhancements
Entities must disclose information on collateral held, such as:
- Nature and carrying amount of collateral
- Terms and conditions
- Whether collateral can be sold or repledged
Such disclosures help users evaluate the entity’s exposure to credit risk and the effectiveness of risk mitigation strategies.
Other Disclosure Requirements
Entities must also disclose:
- Defaults and breaches of loan agreements
- Policies for managing risks
- Changes in accounting policies
- Quantitative data related to risk exposures
These disclosures enhance transparency and accountability, allowing stakeholders to assess the financial health and risk profile of the entity.
Conclusion
Understanding the accounting, presentation, and disclosure of financial instruments is critical for preparing accurate and compliant financial statements. The Indian Accounting Standards, Ind AS 109, Ind AS 32, and Ind AS 107, form a cohesive framework that governs every stage in the lifecycle of financial instruments, from initial recognition to final reporting.
Ind AS 109 lays the foundation by detailing the criteria for recognition and derecognition of financial assets and financial liabilities. It classifies financial instruments based on the business model and contractual cash flow characteristics, and it establishes measurement categories such as amortised cost, fair value through profit or loss, and fair value through other comprehensive income. Moreover, it introduces the expected credit loss model to address impairment in a forward-looking manner and provides comprehensive guidance on hedge accounting.
Ind AS 32 focuses on the correct presentation of financial instruments, particularly the distinction between liabilities and equity. This distinction plays a pivotal role in assessing an entity’s capital structure and financial health. By focusing on the substance of contractual terms rather than merely their legal form, Ind AS 32 ensures that instruments are classified in a way that reflects the underlying economic reality. It also addresses offsetting rules that prevent overstatement of financial positions in the balance sheet.
Ind AS 107 complements the other two standards by enhancing transparency through comprehensive disclosure requirements. It ensures that users of financial statements have the necessary insights to understand the significance of financial instruments, their associated risks, and the management strategies employed by the entity. Disclosures relating to credit risk, market risk, and liquidity risk provide stakeholders with a clearer picture of an entity’s exposure and resilience.
Together, these three standards reinforce each other and create a robust reporting environment for financial instruments. For preparers, an in-depth understanding of these standards is essential not only for compliance but also for presenting a true and fair view of financial position and performance. For users, such as investors and analysts, the consistent application of these standards enhances comparability, decision-making, and trust in financial reporting.
As financial instruments become increasingly complex and integrated into all areas of business operations, the importance of mastering the principles set out in Ind AS 32, 109, and 107 will only grow. Entities must remain diligent in interpreting and applying these standards, continually aligning their accounting practices with evolving financial instruments and regulatory expectations.