ACCOUNTING OF FINANCIAL INSTRUMENTS
A QUICK REVIEW
The following three Indian Accounting Standards are relevant for recognition, measurement and disclosure of financial instruments:
Financial instruments: Presentation (Ind AS 32)
Financial instruments: Disclosure (Ind AS 107)
Financial instruments (Ind AS 109)
Financial Instruments are classified as:
(i) Financial assets,
(ii) Financial liabilities and (iii) Equity instruments.
Ind AS 32 prescribes the requirements for presentation of financial instruments and Ind AS 107 prescribes about disclosure of financial instruments.
Ind As 109 deals with recognition and measurement of financial instruments and hedge accounting.
As per Ind AS 32 in financial statements financial instruments are presented as financial assets or as financial liabilities or equities.
Objectives of the standard:
The objective of this Standard is to establish principles for presenting financial instruments as liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset.
(I) Financial assets are:
(
a) Cash;
(b) An equity instrument of another entity;
(
(
c) A contractual right:
(
i) to receive cash or another nancial asset from another entity; or
(ii) to exchange nancial assets or nancial liabilities with another entity under conditions that are potentially favourable to the entity; or
d) 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 receive a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a xed amount of cash or another nancial asset for a xed number of the entity’s own equity instruments.
(II) A financial liability is any liability that is:
(a) A contractual obligation:
(i) to deliver cash or another nancial asset to another entity; or
(ii) to exchange nancial assets or nancial 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 the exchange of a xed amount of cash or another nancial asset for a xed number of the entity’s own equity instruments.
(III) An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
The instrument is an equity instrument if, and only if, both conditions (a) and (b) below are met.
(a) The instrument includes no contractual obligation:
(i) to deliver cash or another nancial asset to another entity; or
(ii) to exchange nancial assets or nancial liabilities with another entity under conditions that are potentially unfavourable to the issuer.
(b) If the instrument will or may be settled in the issuer’s own equity instruments, it is:
(i) a non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments; or
(ii) a derivative that will be settled only by the issuer exchanging a xed amount of cash or another nancial asset for a xed number of its own equity instruments.
A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future
event or the death or retirement of the instrument holder. Ordinarily it satisfies the conditions of being classified as financial liabilities. Where it entitles the holder a pro rata share of the entity’s net assets on liquidation it is classified as equity.
Ind AS 109: Financial Instruments
Objective:
The objective of this Standard is to establish principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows.
It classifies the financial assets and financial liabilities into three categories for recognition and measurement:
(
i) Measured at fair value through Other Comprehensive Income (OCI).
Conditions for being classified as (FV through OCI):
(
(
a) Objectives of holding nancial asset are both to collect contractual cash ows and to sell nancial assets.
b) Contractual cash ows solely consists of payment of principal and interest on the principal amount outstanding on speci ed dates.
(ii) Measured at amortized cost.
If the objective of holding financial asset does not include collection of cash flows by selling of financial assets, such financial assets are classified as ‘amortized cost.’
(iii) Measured at fair value through P & L
If a financial asset is not classified as amortised cost or an FV through OCI it is measured at fair value through P & L. Simple case for example, if investment in equity of any other company where there is no contractual cash flows for interest or principal.
Ind AS 107: Financial Instruments: Disclosures
Objective:
The objective of this Indian Accounting Standard (Ind AS) is to require entities to provide disclosures in their financial statements that enable users to evaluate:
(a) the significance of financial instruments for the entity’s financial position and performance; and (b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks.
The principles in this Ind AS complement the principles for recognising, measuring and presenting financial assets and financial liabilities in Ind AS 32, Financial Instruments: Presentation, and Ind AS 109, Financial Instruments.
An entity shall disclose information that enables users of its financial statements to evaluate the significance of financial instruments for its financial position and performance.
The carrying amounts of each of the following categories, as specified in Ind AS 109, shall be disclosed either in the balance sheet or in the notes:
(a) Financial assets measured at fair value through pro t or loss,
(b) Financial liabilities at fair value through pro t or loss.
(
c) Financial assets measured at amortised cost.
(d) Financial liabilities measured at amortised cost.
(e) Financial assets measured at fair value through other comprehensive income.
PAST EXAMINATION QUESTIONS
OBJECTIVE QUESTIONS
Q. 1 As per Ind As breach of a long-term loan covenant will lead to classification of loan as a liability payable on demand and classification in the financial statement to be made accordingly as required in the book of borrower when
(a) such breach occurs after the ends of the nancial year and there is no subsequent agreement between borrower and lender.
(
b) such breach occurs after the end of the nancial year and before the issue of the nancial statement.
(
c) such breach occurs before the end of the nancial year and there is an agreement between lender and borrower after the end of the nancial year and before the issue of nancial statement to the effect that lender shall not demand the payment.
(
d) such breach occurs after the end of the nancial year and the lender has sent a demand after requesting immediate payment before the issue of the nancial statement.
[Dec. 2018, 2 Marks]
Ans. (c) such breach occurs before the end of the financial year and there is an agreement between lender and borrower after the end of the financial year and before the issue of financial statement to the effect that lender shall not demand the payment.
Q. 2 Which of the following is not true?
(
a) An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
(
b) A puttable instrument is a nancial instrument that gives the holder the right to put the instrument back to the issuer for cash or another nancial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder.
(
c) Cash, an equity instrument of another entity and a contractual right are Financial Assets.
(d) None of the above [June 2023, 2 Marks]
Ans. (d) None of the above
Q. 3 Ind AS 109: Financial Instruments classifies the financial assets and financial liabilities into the following categories for recognition and measurement:
(a) Measured at fair value through OCI
(b) Measured at amortized cost
(c) Measured at fair value through P & L
(d) All of the above [June 2023, 2 Marks]
Ans. (d) All of the above
Q. 4 When objective of holding financial assets does not include collection of cash flows by selling of financial assets, such financial assets are measured at:
(
a) Fair value through other comprehensive income (OCI)
(b) Amortized cost
(
c) Fair value through pro t and loss (P&L)
(d) None of the above [Dec. 2023, 2 Marks; June 2025, 2 Marks]
Ans. (b) Amortized cost
Q. 5 Financial assets are ________.
(a) Cash
(b) An equity instrument of another entity
(c) A contractual right
(d) All of the above [Dec. 2024, 2 Marks]
Ans. (d) All of the above
Q. 6 An ________ is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
(a) Equity Instrument
(b) Puttable Instrument
(c) Financial Instrument
(d) None of the above [Dec. 2024, 2 Marks]
Ans. (a) Equity Instrument
THEORY QUESTIONS
Q. 1 Write a brief note on initial measurement of financial asset or financial liability under Ind AS 109. [June 2019, 2 Marks]
Ans. Except for trade receivables, at initial recognition, an entity shall measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.
Q. 2 Write a short note on Derivative and an Embedded Derivative as per Ind AS 109. [June 2019, 4 Marks]
Ans.
(i) A Derivative is a Financial Instrument or other contract with the following all three characteristics:
(a) Change in Value: Its Value changes in response to the change in a speci ed Interest Rate, Financial Instrument Price, Commodity Price, Foreign Exchange Rate, Index of Prices or Rates, Credit Rating or Credit Index, or other Variable, provided in the case of a non- nancial variable that the variable is not speci c to a party to the contract (sometimes called the ‘underlying’);
(b) No /Smaller Initial Net Investment: It requires No Initial Net Investment or an initial net investment that is Smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors; and
(c) Settlement at a Future Date: It is settled at a Future Date.
CORPORATE FINANCIAL REPORTING
(ii) An Embedded Derivative is a component of a hybrid (combined) instrument that also includes a non-derivative host contract, with the effect that some of the cash flows of the combined instrument vary in a way similar to a standalone derivative.
Note: A derivative that is attached to a financial instrument but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, is not an embedded derivative, but a separate financial instrument.
Q. 3 Define Financial Asset, an equity instrument and a puttable instrument as per Ind AS 32. [June 2023, 6 Marks]
Ans.
Financial assets are:
(
a) cash;
(b) an equity instrument of another entity,
(c) a contractual right:
(i) to receive cash or another nancial asset from another entity; or
(ii) to exchange nancial assets or nancial liabilities with another entity under conditions that are potentially favourable to the entity;
(d) 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 receive a variable number of the entity’s own equity instruments; or Accounting of Financial Instruments,
(ii) a derivative that will or may be settled other than by the exchange of a xed amount of cash or another nancial asset for a xed number of the entity’s own equity instruments.
Equity Instrument:
An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
Puttable Instrument:
A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder. Ordinarily, it satisfies the conditions of being classified as financial liabilities. Where it entitles the holder to a pro-rata share of the entity’s net assets on liquidation it is classified as equity.
NUMERICAL PROBLEMS
Q. 1 Mega Ltd. issued 4,00,000, 6% Convertible Debentures of ` 10 each on 1st April, 2011. The debentures are due for redemption on 31st March, 2015 at a premium of 10%, convertible into equity shares to the extent of 50% and the balance to be settled in cash to the debenture holders. The Interest rate on equivalent debentures without conversion rights was 10%. You are required to separate the debt and equity components at the time of the issue and show the accounting entry in the company’s books at initial recognition. Interest Rate Year 1 Year 2
The following Present Values of ` 1 at 6% and at 10% are supplied to you. [Dec. 2015, 5 Marks]
Ans.
Computation of Debt component of Convertible Debentures as on 1.4.2015:
× 50%]
Total Present Value of Debt Component (A) 22,56,800
Issue Proceeds from Convertible Debt (B) 40,00,000
Value of Equity Component (B – A) 17,43,200
Journal entry at initial recognition:
Bank A/c Dr.
To 6% Convertible Debentures (Liability Component) A/c
To 6% Convertible Debentures (Equity Component) A/c
(Being the disbursement recorded at fair value)
40,00,000 22,56,800 17,43,200
Q. 2 PARASHI Ltd. granted ` 15 lakh loan to its employees on April 1, 2015 at a concessional interest rate 4% per annum. Loan is to be repaid in five equal annual installments along with interest. Market rate of interest for such loan is 10% per annum.
Required:
(i) Record the entries for the year ended 31st March, 2016 for the loan transaction.
(ii) At what value loan should be recognized initially and also calculate the amortized cost for all the subsequent ve years, keeping in view provisions of Ind AS-109.
Given: The present value of ` 1 receivable at the end of each year based on discount factor of 10% is as under:
Ans.
(i) Calculation of Initial Recognition Amount of Loan to Employees:
ended March, 31
Entries:
(1) Employee Loan A/c
3,27,276 2,87,587 2,52,437 2,21,292 1,93,721
To Bank A/c 15,00,000 15,00,000 (2) Employee Expenses
To Employee Loan A/c 2,17,687 2,17,687
As the value of loan is ` 12,82,313. It will be initially recognized at this value and balance amount debited to Employee Expense account.
(ii) Calculation of amortized cost of loan to employees at the end of each year:
12,82,313 10,50,544 8,07,598 5,52,358 2,83,594 1,28,231 1,05,054 80,760 55,236 28,406 (Balancing fig.) 3,60,000 3,48,000 3,36,000 3,24,000 3,12,000 10,50,544 8,07,598 5,52,358 2,83,594 Nil
Q. 3 RICH & POOR Ltd. issued certain callable convertible debentures at ` 300. The value of similar debentures without call or equity conversion option is 285. The value of call as determined using Black and Scholes model for option pricing is 10. Determine Values of Liability and Equity Component. [June 2023, 3 Marks]
Ans.
A callable bond is one that gives the issuer the right to buy the bond from the bondholders at a specified price. This feature in effect is a call option written by the bondholder. The option premium (value of call) is payable by the issuer.
Value of Liability Component = 285 – 10 = ` 275
Value of Equity Component = 300 – 275 = ` 25
Q. 4 At the beginning of year 1, BLACK PEPPER TULSI Ltd. issued 40,000 convertible debentures with face value 100 per debenture, at par. The debentures have six-year term. The interest at annual rate of 9% is paid half-yearly. The bondholders have an option to convert half of the face value of debentures into 2 Equity Shares at the end of year 3. The bondholders not exercising the conversion option will be repaid at par to the extent of 50 per debenture at the end of year 3. The non-convertible portion will be repaid at 10% premium at the end of year 6. At the time of issue, the prevailing market interest rate for similar debt without conversion option was 10.25%.
Required:
Compute Value of Embedded Derivative. Pass the Journal Entry at initial recognition.
[Given PV of Annuity of 1 at 5% for 6 years 5.076, for 12 years 8.863, PV of 1 at 5% at for 12th year end 0.557]
[June 2023, 6 Marks; Similar Question in Dec. 2023, 7 Marks]
Ans.
Discount Rate Compounded half yearly = 10.25
[1 + R/(100 × 2)]2 = 1.1025
1 + R/(100 × 2) = 1.05
R/200 = 0.05
R = 10%
Half Yearly Rate = 5%
Computation of Debt component of Convertible Debentures as on 1.4.2015:
