Indian Accounting Standards (Ind AS) 32 Financial Instruments
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Let us first of all take up the definition of ‘Financial Instrument’ from Ind AS 32:
Paragraph 11 of Ind AS 32:
“A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.” Looking at the above definition one thing is pretty clear that there has to be a ‘contract’. We all know that contract is always entered between 2 parties. So, which 2 parties are we referring to in this definition?
Another thing which one can interpret from the above definition is that the decision is to be taken by the issuer when it PRESENTS (emphasis added – Ind AS 32 deals with presentation) the instrument in the Balance Sheet. Thus, we can easily interpret the definition as under: When there is a contract between 2 parties (Issuer and Holder), the issuer needs to decide whether to present the instrument as a ‘Financial Liability’ (loan/debt funds) or ‘Equity Instrument’ (Own funds). The Holder would always land up calling it as a “Financial Asset’.
Thus, there are a total 3 terms with which we can appreciate the definition of ‘Financial instrument’.
1. Financial Liability 2. Equity Instrument 3. Financial Asset My experience has given me an understanding on the basis of which I have developed a 3-step criteria approach of identifying whether a given instrument is a ‘Financial Liability’ or ‘Equity Instrument’. Thus, without taking the definition of ‘Financial Liability’ or ‘Equity Instrument’ let me elaborate the 3-step criteria with examples. Step 1:
Example: Income tax is payable to government. But this is a obligation which is ‘statutory’ in nature. Thus, Ind AS 12 applies. Step 2:
Note: I am not discussing the case where the contractual obligation will be discharged in a combination of cash and equity shares. Step 3: 
Note: I have not discussed how to decide it is derivative or non-derivative in nature. There are 3 parameters just to mention to determine the same. Let us take some examples to apply our understanding. Example 1: C Ltd. issues convertible debentures to P Ltd. for a subscription amount of Rs. 100 crores. Those debentures are convertible (emphasis added) after 5 years into equity shares of C Ltd. using a pre-determined formula. The formula is: 100 crores × (1 + 10%) ^5 ————————————— Fair value on date of conversion
Examine the nature of the financial instrument?
At the first instance I would like to mention that this instrument is a case of ‘mandatory conversion’ thus, it is non-derivative in nature.
Step 1: Is there an obligation which is contractual in nature for C Ltd.? Yes.
Step 2: How will C Ltd. settle/discharge the above obligation? Equity Shares.
Step 3: What is the nature of contract? Non-derivative. Therefore, we need to apply ‘Fixed Test’ i.e. No of shares to be issued is fixed or variable. C Ltd. uses a variable number of its own equity instruments as a means to settle the contract.
Conclusion: Financial Liability.
Example 2: C Ltd. issues convertible debentures to J Ltd. for a subscription amount of Rs. 100 crores. Those debentures are convertible after 5 years into 15 crore equity shares of Rs. 10 each.
Examine the nature of the financial instrument?
At the first instance I would like to mention that this instrument is a case of ‘mandatory conversion’ thus, it is non-derivative in nature.
Step 1: Is there an obligation which is contractual in nature for C Ltd.? Yes.
Step 2: How will C Ltd. settle/discharge the above obligation? Equity Shares.
Step 3: What is the nature of contract? Non-derivative. Therefore, we need to apply ‘Fixed Test’ i.e. No of shares to be issued is fixed or variable. C Ltd. uses a fixed number of its own equity instruments as a means to settle the contract.
Conclusion: Equity Instrument.
Example 3: B Ltd. issues warrants (emphasis added) to all existing shareholders entitling them to purchase additional equity shares of A Ltd. (with face value of Rs. 100 per share) at an issue price of Rs. 150 per share.
Evaluate the nature of financial instrument? At the first instance I would like to mention that this instrument is a case of an ‘option’ where the shareholder gets an option to buy shares. Thus, it is derivative in nature.
Step 1: Is there an obligation which is contractual in nature for B Ltd.? Yes.
Step 2: How will B Ltd. settle/discharge the above obligation? Equity Shares.
Step 3: What is the nature of contract? Derivative. Therefore, we need to apply ‘Fixed for Fixed Test’ i.e. Both ‘Consideration’ and ‘No of shares’ to be issued is fixed. Consideration is fixed at Rs. 150; No. of Equity shares to be issued = 1; i.e. fixed.
Conclusion: Equity Instrument.
Author: CA. Kapileshwar Bhalla
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