There are 3 Ind AS dealing with Financial Instruments:-
1. Financial Instruments-Presentation(IND AS-32)
2. Financial Instruments-Recognition & Measurement(IND AS-109)
3. Financial Instruments-Disclosures(IND AS-107)
What is ‘Financial Instrument’?
Paragraph 11 of Ind As 32 defines:
A financial instrument is any contract that give rise to a financial asset of one entity and a financial liability or equity instrument of another entity.
Parties to Financial Instruments:
In case of Financial Instruments, the two parties are called:
- Issuer of an Instrument who presents it on the Liability side of the Balance Sheet as per Schedule III- Division II.
- Holder of an Instrument who presents it on the Asset side of the Balance Sheet as per Schedule III- Division II.
Note:- IND AS 32 deals with the presentation of Financial Instruments in the Balance Sheet. Typically, it is the Issuer who needs to decide whether the instrument is to be presented as financial liability or equity instrument. Irrespective the holder would always present it as financial asset.
An analysis of Schedule III- Division II gives us an insight as under:
1. Asset segregated into non-current and current; further segregated in terms on non-financial and financial in nature.
2. Liability is segregated into Equity and Liability; liabilities are split in terms of non-current and current and further segregated in terms of non-financial and financial in nature.
Now there are 3 main key terms in definition of Financial Instruments:
→Financial Liability
→Financial Asset
→Equity Instruments
What is a ‘Financial Liability’?
Paragraph 11 of Ind As 32 defines:
A financial liability is any liability that is
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity;or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by way of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose rights, options or warrants to acquire a fixed number of entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments. Apart from the aforesaid, the the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency.
Also, for these purposes the the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with Paragraph 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or deliver of the entity’s own equity instruments.
As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the condition in paragraphs 16A and 16B or Paragraph 16C and 16D.
Decoding definition of Financial Liability:-
FINANCIAL LIABILITY
Point(a)- Clause(i)-To deliver cash/another financial asset
Clause(ii)- Exchange under conditions potentially unfavourable
Point(b)- Clause(i)- Non-derivative Failure of ‘Fixed Test’
Clause(ii)- Derivative Failure of ‘Fixed for Fixed Test’
– Clarifications: a) Rights, options, warrants b)(CARVE OUT) Foreign Currency Convertible Bonds(FCCB) c) Equity instruments not to include ‘Deemed Equity Instruments’
Aspect 1:- Any Liability:
It includes
- Actual Liability
- Contingent liability
- Derivative liability
- Non-Derivative Liability
Aspect 2:- Contractual obligation:
There has to be an obligation which is contractual in nature. For example:- Income tax to be paid to government is an obligation but not contractual in nature. It is statutory in nature; therefore, would not be a financial liability.
Aspect 3:- Ways in which the contractual obligation is discharged:
Note:
Not all the ways have been discussed at this stage.
Point(a)(i) of the definition:- Cash(includes through bank and cash and cash equivalents) or another Financial Assets
Point(b)(i) of the definition:- Own equity instruments(but variable in number)
Special Issues:
Point (a)(ii)- Exchange
Point(b)(ii)- Derivative
Important Point:- IND AS 32 recognizes the use of own equity instruments as a medium of settlement of an obligation.This concept is called in case of non-derivative “Fixed Test”.
In simple words,
- If an entity issues Fixed no. of equity instruments it passes Fixed Test and the instrument is not a financial liability in that case.
- If an entity issues Variable no. of equity instruments it fails the Fixed Test and the instrument is a financial liability in that case.
Aspect 4:- Rights, options or warrants:
‘Rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers rights, options or warrants pro rata to all of its existing owners of same class of its own non-derivative equity instruments’.
Aspect 5:- Equity conversion option embedded in a convertible bond denominated in foreign currency(FCCB):
‘Equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency’.
CARVE OUT:- The position in IND AS is different from IFRS, As per IFRS (i.e. IAS 32):
As per accounting treatment prescribed under IAS 32:
- Equity conversion option
- In case of foreign currency denominated convertible bonds (FCCBs)
- Is considered a derivative liability which is embedded in the bond
Gains or losses arising on account of change in fair value of the derivative need to be recognised in the Statement of profit or loss as per IAS 32.
Carve out (Based on IND AS 32):
In Ind AS 32, an exception has been included to the definition of a “Financial Liability” in Paragraph 11(b)(ii), whereby:
- Conversion option in a convertible bond denominated in foreign currency to acquire a fixed number of entity’s own equity instruments is classified as an equity instrument if the exercise price is fixed in any currency.
Aspect 6:- Entity’s own equity instruments do not include….
‘Also, for these purposes the the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with Paragraph 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or deliver of the entity’s own equity instruments’.
Important Point:- Ind AS 32 in the definition of Financial Liability gives us 3 instruments which are not considered as equity instruments for settlement of financial liability; though they are regarded as ”deemed equity instruments”
1. Puttable financial instruments:- Classified as equity instruments if all conditions of Paragraph 16A and 16B are met.
2. Instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity on liquidation:- Classified as equity instruments if all conditions of Paragraph 16C and 16D are met.
3. Instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.
Aspect 6:- Exception:- “As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meet the conditions in paragraphs 16A and 16B or paragraphs 16C or 16D.
NOTE:- These are technically called “Deemed Equity Instruments”. They are ‘Financial Liabilities’ but treated as ;Equity Instruments’ if certain conditions are met.
1. Financial Liability + All conditions of Paragraph 16A & 16B are met = Deemed Equity Instruments
2. Financial Liability + All conditions of Paragraph 16C & 16D are met = Deemed Equity Instruments
Special Issue-1:- Exchange:- To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable.
Example:- P Ltd takes a short position in a call option with A Ltd (long position) to subscribe P Ltd’s. equity share at a price of Rs.200 per share. Now if on the balance sheet date, market value of equity share of P Ltd is Rs.210 per share, P Ltd. will be obliged to pay Rs.10 to settle the option. Such a condition is potentially unfavourable to P Ltd. and hence Rs.10 represents a financial liability for P Ltd.
Special Issue-2:- Derivative:- “A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of entity’s own equity instruments”.
This concept is called in derivative “Fixed for Fixed Test”.
In simple words,
Fixed Consideration + Fixed No. of Equity Instruments to be issued in settlement = Fixed for Fixed Test
Summary for Fixed Test and Fixed for Fixed Test
1. Non-Derivative (Passes Fixed Test)- It is an Equity Instruments
2. Non-Derivative (Fails Fixed Test)- It is a Financial Liability
3. Derivative (Passes Fixed for Fixed Test)- It is an Equity Instruments
4. Derivative (Passes Fixed for Variable Test)- It is a Financial Liability
5. Derivative (Passes Variable for Fixed Test)- It is a Financial Liability
6. Derivative (Passes Variable for Variable Test)- It is a Financial Liability
What is an ‘Equity Instrument”?
Paragraph 11 of Ind As 32 defines:
An equity instrument ‘is any contract that evidences a residual interest in the asset of an entity after deducting all of its liabilities’.
Examples:-
- Non-Puttable ordinary shares’
- Some puttable instruments(which met the conditions of Paragraph 16A and 16B)
- Some instruments that impose on the entity an obligation to deliver another party a pro rata share of the net assets of the entity only on liquidation(which met the conditions of Paragraph 16C and 16D)
- Some types of preference shares
- Warrants or written call options that allow the holder to subscribe for or purchase of a fixed number of non-puttable ordinary shares in the issuing entity in exchange for a fixed amount of cash or another financial asset.
Puttable Instrument:- Paragraph 11 of Ind AS 32 defines, a puttable instrument is a financial instrument that gives the holder the right to put instrument back to the issuer for cash or another financial asset or is automatically put back to issuer on the occurrence of an uncertain future event or death or retirement of the instrument holder.
A puttable financial instrument includes a contractual obligation for the issuer to repurchase or redeem that instrument for cash or another financial asset on exercise of the put.
CONDITIONS IN PARAGRAPH 16A and 16B:-
- Paragraph 16A conditions are Instrument specific conditions (Conditions a to e)
- Paragraph 16B conditions are Issuer specific conditions (Conditions a & b)
A) Instrument Specific Conditions:-
♦ Condition (a): It entitles the holder to a pro-rata share of the entity’s net assets in the event of entity’s liquidation
where, pro-rata share= Entity’s Net assets on liquidation/No. of units * No. of units held by the FI Holder
♦ Condition (b): The instrument in the class of instruments that is subordinate to all other class of instruments.
Note:- It has no priority over other claims to the assets of the entity on liquidation.
♦Condition (c): All financial instruments in the class of instruments that is subordinate to all other class of instruments have identical features.
♦Condition (d): Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset the instrument does not include any contractual obligation:
Parameter 1:-
- To deliver cash or another financial asset to another entity or
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity.
Parameter 2:-
- It is not a contract that will or may be settled in the entity’s own equity instruments.
♦ Condition (e): The total expected cash flows attributable to the instrument over the life of instrument are based substantially on:
- The profit or loss
- The change in recorded net assets; or
- The change in the fair value of the recognised and unrecognized net assets of the entity over the life of the instrument(excluding any effects of the instrument)
B) Issuer Specific Conditions:-
♦Condition (a): Total cash flows must be based substantially on the factors as mentioned above in condition(e).
♦Condition (b): The effect of substantially restricting or fixing the residual return to the puttable instrument holders.
Note:- The above clause is an ‘Anti-abuse clause’ which ensures that puttable instruments are not artificially structured to satisfy conditions (a) to (e) above and at the same time the holder of that puttable instrument also holds another financial instrument or has entered into another contract with the issuer whose cash flows indirectly restrict or fix the return on puttable instrument.
CONDITIONS IN PARAGRAPH 16C and 16D:-
- Paragraph 16C conditions are Instrument specific conditions (Conditions a to c)- Same as of Paragraph 16A
- Paragraph 16D conditions are Issuer specific conditions (Conditions a & b)- Same as of Paragraph 16B
Some types of Preference shares:-
Preference shares may be issued with various rights. In determining whether a preference share is a financial liability or an equity instrument, an issuer assessed the particular rights attracting to the share to determine whether it exhibits fundamental characteristics of a financial liability.
Preference shares are evaluated from 2 point of view:-
1. Redemption point of view:
Case-1:- Redemption at a specified date; or Redemption at the option of holder:- A preference share that provides for redemption on a specified date or at the option of holder contains a financial liability because the issuer has an obligation to transfer financial assets to the holder of the share.
→The potential inability of an issuer to satisfy an obligation to redeem a preference share when contractually required to do so, whether because lack of funds, a statutory restriction or insufficient profit or reserves, does not negate the obligation.
Case-2:- Redemption at the option of the issuer: An option of the issuer to redeem the shares for cash does not specify the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholder.
→In this case, redemption of the shares is solely at the discretion of the issuer.
An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares.
Case-2:- Preference shares are non- redeemable:- When preference shares are non- redeemable, the appropriate classification is determined by the other rights that attach to them.
Classification is based on an assessment of the substance of the contractual arrangement and the definitions of a financial liability and an equity instrument.
2. Distribution point of view:
When distribution to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments.
In cases where the preference shares are irredeemable, it is like an equity instrument. But if they are entitled to dividend, the obligation to pay dividend meets the definition of financial liability.
The instrument in such cases have 2 components:-
- Financial liability represented by dividend.
- Equity component represented buy the issue price.
Such instruments are technically called ‘Compound Financial Instruments’.
Note:- The classification of a preference shares as an equity instrument or a financial liability is not affected by:-
- a history of making distributions
- an intention to make distributions in the future
- a possible negative impact on the price of ordinary shares of the issuer if the distributions are not made (because of restrictions on paying dividends on the oridinary shares if the dividends are not paid on the preference shares).
- the amount of the issuer’s reserves
- an issuer’s expectation of a profit or loss for a period
- an ability or inability of the issuer to influence the amount of its profit or loss for the period
What is a ‘Financial asset”?
Financial asset is same as defined in financial liability except 3 differences:-
- Financial asset is contractual right whereas financial liability is a contractual obligation.
- Financial liability is an obligation to deliver cash or another financial asset to another entity whereas financial asset is an obligation to receive.
- In financial liability exchange is made under conditions potentially unfavourable whereas in financial assets exchange is made under
- conditions potentially favourable
Compound Financial Instrument:- A common form of a compound financial instrument is a debt instrument with an ‘embedded conversion option’ and without any other embedded derivative features. Example:- A bond convertible into ordinary shares of the issuer.
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How to treat Non Cumulative Redeemable Preference Share who are not entitled to convert their RPS into Equity Shares?