Financial instruments: Ind AS 32, 107 and 109

In short

Ind AS 32 decides presentation - whether an instrument issued by a company is a financial liability or equity, and when assets and liabilities may be offset. Ind AS 109 decides recognition and measurement - classification of financial assets, amortised cost using the effective interest method, impairment on an expected credit loss basis, derecognition and hedge accounting. Ind AS 107 prescribes disclosure - the significance of financial instruments and the credit, liquidity and market risks they carry. The three are examined heavily in CA Final Paper 1 (Financial Reporting) and CA Inter Advanced Accounting, and are daily work in audit, financial reporting, treasury and NBFC/banking roles. Classification of preference shares and convertible debentures, EIR computation and ECL provisioning are the highest-frequency exam and interview areas.

Explained

Scope, definitions and the liability-versus-equity test (Ind AS 32)

• A financial instrument is a contract giving rise to a financial asset of one entity and a financial liability or equity instrument of another.
• Financial asset: cash; equity instrument of another entity; a contractual right to receive cash or another financial asset; or a derivative asset. Prepaid expenses, advance to supplier for goods, inventory and PPE are *not* financial assets - no contractual right to cash.
• Financial liability: a contractual obligation to deliver cash or another financial asset, or to exchange assets on potentially unfavourable terms; or a contract settled in a variable number of own shares. Statutory dues (GST, income tax payable) are not financial liabilities - they arise from law, not contract.
• Equity instrument: a residual interest in net assets - no contractual obligation to deliver cash.
• Decision rules used in exams:
  1. Redeemable preference shares (mandatory redemption or holder's put) = financial liability; dividend on them is finance cost in P&L.
  2. Irredeemable, discretionary-dividend preference shares = equity.
  3. Compulsorily convertible into a fixed number of equity shares = equity (fixed-for-fixed); convertible into a variable number worth a fixed amount = liability.
  4. Optionally convertible debentures = compound instrument - split into liability and equity.
• Substance over form: the legal name is irrelevant; the contractual obligation decides.
• Compound instrument split (residual method): liability component = present value of contractual cash flows discounted at the market rate for a similar instrument *without* the conversion option; equity component = total proceeds − liability component. The equity component is never remeasured.
• Treasury shares (own shares bought back) are deducted from equity; no gain or loss goes to P&L on their purchase, sale or cancellation.
• Transaction costs of issuing equity are debited to equity (net of tax benefit); those on a liability are deducted from its carrying amount and absorbed into the EIR; for a compound instrument they are allocated pro rata.
• Offsetting (Ind AS 32.42): present net only if there is a *legally enforceable* right of set-off and an intention to settle net or simultaneously - both conditions, not either.
• Indian carve-out: for foreign-currency convertible bonds (FCCBs), the conversion option is treated as equity if the exercise price is fixed in any currency - under IAS 32 it would be a derivative liability.

Classification and measurement of financial assets (Ind AS 109)

• Classification rests on two tests applied together: the business model and the contractual cash flow characteristics (SPPI).
• SPPI test: are the cash flows solely payments of principal and interest - interest meaning time value of money, credit risk, other basic lending risks and a profit margin? Leverage, equity-linked returns and non-genuine features fail.
• Three categories for debt instruments:

• Equity investments are FVTPL by default; an entity may make an irrevocable election, instrument by instrument, to present fair value changes in OCI with no recycling - only dividends go to P&L. Not available for held-for-trading equity.
• Fair value option: a financial asset may be designated at FVTPL on initial recognition if it eliminates an accounting mismatch; a liability may be so designated if it removes a measurement inconsistency or it contains an embedded derivative.
• Initial recognition at fair value; transaction costs are added (assets) or deducted (liabilities) except for FVTPL items, where they go straight to P&L. Short-term trade receivables without a significant financing component are measured at the transaction price under Ind AS 115.
• Reclassification of financial assets is permitted *only* on a change in business model - rare, prospective, no restatement. Financial liabilities are never reclassified.
• Financial liabilities are at amortised cost, except held-for-trading, derivatives and those designated at FVTPL. For FVTPL-designated liabilities, the portion of fair value change due to own credit risk goes to OCI and is not recycled.
• Embedded derivatives: in a financial *asset* host, no separation - the whole hybrid is assessed under SPPI. In a financial *liability* or non-financial host, separate if not closely related, the host is not at FVTPL, and the embedded feature meets the derivative definition.
• Derecognition of an asset: when the contractual rights expire, or on transfer where substantially all risks and rewards pass. If risks and rewards are retained, the asset stays on the books (secured borrowing); if neither transferred nor retained, apply the control test and, where control is retained, continuing involvement accounting. Bill discounting with recourse usually fails derecognition.
• Derecognition of a liability / modification: if the revised terms change the present value of cash flows (discounted at the original EIR) by 10% or more, the modification is substantial - extinguish the old liability, recognise the new at fair value and take the difference to P&L. If below 10% (non-substantial), recompute the carrying amount using the original EIR and recognise the gain or loss immediately.

Impairment: the expected credit loss model

• Ind AS 109 replaced the old "incurred loss" approach with a forward-looking ECL model - a loss allowance is recognised on day one, before any default event.
• Scope: amortised cost assets, FVOCI debt instruments, lease receivables, contract assets, loan commitments and financial guarantees issued. Equity instruments and FVTPL assets are outside it.
• General (three-stage) approach:
  • Stage 1 - no significant increase in credit risk since origination: 12-month ECL; interest on gross carrying amount.
  • Stage 2 - significant increase in credit risk (SICR) but not credit-impaired: lifetime ECL; interest still on gross amount. A rebuttable presumption of SICR applies at more than 30 days past due.
  • Stage 3 - credit-impaired: lifetime ECL; interest on the net (gross less allowance) carrying amount.
• Simplified approach: lifetime ECL always, no stage assessment - mandatory for trade receivables and contract assets without a significant financing component, and an election for those with one and for lease receivables. Usually applied through an ageing-based provision matrix.
• ECL must be (i) probability-weighted, (ii) reflect the time value of money (discounted at the original EIR), and (iii) use reasonable and supportable forward-looking information - not just historical loss rates.
• Purchased or originated credit-impaired (POCI) assets use a credit-adjusted EIR and recognise only *changes* in lifetime ECL.
• FVOCI debt: the ECL allowance is recognised in P&L but credited to OCI, not against the asset's carrying amount (the asset is already at fair value).
• Write-off when there is no reasonable expectation of recovery; it is a derecognition event, not an additional expense if already provided.
• Indian practice: NBFCs and HFCs apply Ind AS (phased from FY 2018-19) and report both ECL and the RBI's IRACP provision, disclosing the shortfall in an impairment reserve per RBI's March 2020 circular. Banks continue with RBI's IRACP norms - Ind AS for banks is deferred; the RBI has issued draft directions for an expected-loss provisioning framework for banks, with the transition arrangements still being finalised.

Hedge accounting (Ind AS 109)

• Purpose: to remove the mismatch between a derivative measured at FVTPL and the hedged exposure that is not.
• Qualifying criteria: eligible hedging instrument (generally a derivative; a non-derivative only for FX risk or an FVTPL instrument) and eligible hedged item; formal designation and documentation at inception; and an effectiveness assessment showing an economic relationship, credit risk not dominating, and an appropriate hedge ratio. Ind AS 109 is principles-based - the old 80-125% bright line of IAS 39 is gone, and there is no retrospective effectiveness test.
• Three types:
  1. Fair value hedge - hedging fair value changes of a recognised asset/liability or firm commitment. Both the derivative and the hedged item (for the hedged risk) are remeasured through P&L; the offsetting leaves only ineffectiveness.
  2. Cash flow hedge - hedging variability in cash flows of a highly probable forecast transaction or a floating-rate item. The effective portion goes to the Cash Flow Hedge Reserve in OCI (lower of cumulative derivative gain/loss and cumulative change in the hedged cash flows); the excess (ineffectiveness) goes to P&L. The reserve is later reclassified to P&L when the hedged item affects P&L, or capitalised into the cost of a non-financial asset (basis adjustment).
  3. Hedge of a net investment in a foreign operation - treated like a cash flow hedge; recycled on disposal.
• Rebalancing the hedge ratio is required when the economic relationship changes; voluntary discontinuation is not allowed while the criteria are met.
• Costs of hedging: forward element of a forward, foreign currency basis spread and time value of an option may be excluded from designation and deferred in OCI.
• Ind AS 109 does not carry IFRS 9's option to continue IAS 39 hedge accounting (there is no Ind AS equivalent of IAS 39), so its own model must be applied.
• Natural hedge without documentation gets no hedge accounting - a common exam trap.

Disclosures (Ind AS 107) and Indian regulatory context

• Significance: carrying amount of each category; items designated at FVTPL; reclassifications; collateral given and held; defaults and breaches; allowance account reconciliation; net gains/losses by category; total interest income and expense computed by the effective interest method.
• Credit risk: maximum exposure, credit quality by stage/rating, a reconciliation of the loss allowance from opening to closing, inputs and assumptions used in ECL, write-offs, modified assets and collateral.
• Liquidity risk: a contractual maturity analysis of financial liabilities (undiscounted cash flows) with how liquidity risk is managed.
• Market risk: a sensitivity analysis for currency, interest rate and other price risk, showing the effect on profit and equity of a reasonably possible change; or a value-at-risk style analysis.
• Fair value amounts and valuation techniques are disclosed; the three-level hierarchy (Level 1 quoted prices, Level 2 observable inputs, Level 3 significant unobservable inputs) comes from Ind AS 113.
• Fitment in Indian law: Ind AS are notified under section 133 of the Companies Act, 2013 read with the Companies (Indian Accounting Standards) Rules, 2015; presentation follows Schedule III, Division II. Non-Ind AS companies instead apply AS 13 (Accounting for Investments) and the Act's own rules - AS 30/31/32 were withdrawn by the ICAI and never notified - so there is no ECL or compound-instrument split. Buy-back of shares under section 68 affects equity only (and from 1 April 2026 buy-back proceeds are taxed as capital gains in the shareholder's hands under the Finance Act, 2026).

Key points

• Financial instrument - a contract creating a financial asset for one party and a financial liability or equity for the other.
• Liability vs equity - a contractual obligation to deliver cash makes it a liability, whatever it is called.
• Fixed-for-fixed - conversion into a fixed number of own shares for a fixed amount is equity; a variable number is a liability.
• Compound instrument - liability measured first at the PV of cash flows at the market rate for similar non-convertible debt; equity is the residual.
• Preference dividend on a liability-classified instrument is finance cost, not an appropriation.
• Offsetting needs a legally enforceable right of set-off and intent to settle net - both.
• Treasury shares are a deduction from equity; no P&L impact ever.
• SPPI + business model together drive classification into amortised cost, FVOCI or FVTPL.
• Equity FVOCI election is irrevocable and has no recycling; dividends still go to P&L.
• Transaction costs are expensed for FVTPL items, capitalised into carrying amount otherwise.
• EIR is the rate discounting all expected contractual cash flows (including fees and transaction costs) to the net carrying amount.
• ECL is forward-looking and recognised from day one; 12-month in Stage 1, lifetime in Stages 2 and 3.
• Simplified approach - lifetime ECL by provision matrix, mandatory for plain trade receivables.
• Stage 3 interest accrues on the net carrying amount, not the gross.
• 10% test - a change in PV of cash flows of 10% or more on a liability modification means extinguishment.
• Hedge accounting requires documentation at inception; Ind AS 109 dropped the 80-125% bright line.
• Cash flow hedge reserve holds the effective portion in OCI; ineffectiveness goes straight to P&L.
• Own credit risk change on an FVTPL-designated liability goes to OCI and is never recycled.

Formulas and examples

Example 1 - Compound instrument (convertible debentures). On 1 April 2026, X Ltd issues 10,000 optionally convertible debentures of ₹1,000 each (₹1,00,00,000), 3-year term, 6% coupon annually, redeemable at par if not converted. Market rate on similar non-convertible debt is 10%.

• Discount factors at 10%: 0.909091, 0.826446, 0.751315 → annuity factor = 2.486852.
• Liability = (6,00,000 × 2.486852) + (1,00,00,000 × 0.751315) = 14,92,111 + 75,13,148 = ₹90,05,259.
• Equity component = 1,00,00,000 − 90,05,259 = ₹9,94,741 (never remeasured).
• Journal: Bank Dr 1,00,00,000; To Debenture liability 90,05,259; To Equity - conversion option 9,94,741.

Finance cost in Year 1 is ₹9,00,526, not the ₹6,00,000 coupon.

Example 2 - EIR with transaction costs. Y Ltd buys a 3-year bond, face ₹10,00,000, coupon 8% annually, for ₹9,50,000 plus ₹10,000 brokerage; business model is hold-to-collect. Initial carrying amount = ₹9,60,000. Cash flows: 80,000, 80,000, 10,80,000.

• Test 9.6%: factors 0.912409, 0.832489, 0.759573 → PV = 80,000 × 1.744898 + 10,80,000 × 0.759573 = 1,39,592 + 8,20,339 = ₹9,59,931 ≈ 9,60,000. So EIR ≈ 9.6%.
• Year 1: interest income = 9,60,000 × 9.6% = ₹92,160; cash 80,000; closing = 9,60,000 + 92,160 − 80,000 = ₹9,72,160.
• Had brokerage been expensed (wrong for amortised cost), profit would be understated by ₹10,000 in Year 1 and interest income misstated throughout.

Example 3 - ECL by provision matrix (simplified approach). Z Ltd's trade receivables at 31 March 2027:

Allowance required ₹2,55,000. If the existing allowance is ₹1,80,000, charge ₹75,000 to P&L (impairment loss on financial assets). Net receivable in the balance sheet = ₹85,45,000.

Example 4 - Stage movement on a loan. A Ltd (an NBFC) has a loan with EAD ₹50,00,000, 12-month PD 2%, lifetime PD 12%, LGD 40%.

• Stage 1 allowance = 50,00,000 × 2% × 40% = ₹40,000.
• Borrower slips 45 days past due → SICR presumed, move to Stage 2: allowance = 50,00,000 × 12% × 40% = ₹2,40,000; incremental charge to P&L = ₹2,00,000. Interest still accrues on the gross amount.
• If the loan becomes credit-impaired (Stage 3) and the allowance is ₹20,00,000, interest thereafter accrues on the net amount of ₹30,00,000.

Example 5 - Cash flow hedge of an import payable. B Ltd has a highly probable purchase commitment of USD 1,00,000 due 30 June 2027 and on 1 January 2027 buys a forward at ₹84.00/USD. At 31 March 2027 the forward rate for 30 June 2027 is ₹85.20.

• Fair value of forward = 1,00,000 × (85.20 − 84.00) = ₹1,20,000 gain (ignoring the small discounting effect).
• Entry: Derivative asset Dr ₹1,20,000; To Cash Flow Hedge Reserve (OCI) ₹1,20,000, to the extent effective. Without documented designation at inception, the whole ₹1,20,000 would hit P&L as an FVTPL derivative gain.
• When the inventory is purchased, the reserve is adjusted against the cost of inventory (basis adjustment) and flows to P&L as the inventory is sold.

Where it is used

• NBFCs, HFCs and microfinance companies - ECL models with PD/LGD/EAD, staging, the RBI impairment reserve and Ind AS 107 credit risk tables; a core skill for reporting and risk analysts at Bajaj Finance, HDB Financial, Shriram, Muthoot.
• Statutory audit and assurance - testing classification, EIR workings, ECL assumptions and hedge documentation at Big Four and Indian firms; a frequent ICAI Financial Reporting Review Board observation area.
• Corporate treasury - forwards, options and interest rate swaps on INR-USD exposures and external commercial borrowings, with hedge documentation and sensitivity disclosures.
• Fundraising and structuring - whether CCPS/CCDs issued to private-equity investors sit in equity or in borrowings, which drives debt-equity ratios and covenants; a standard diligence question in Indian start-up and PE deals.
• Equity research and credit rating - adjusting reported borrowings for liability-classified preference shares and reading the ECL reconciliation to judge asset quality.
• Exams - CA Final Paper 1, CA Inter Advanced Accounting, CMA Final, and Ind AS questions in CFA/Diploma in IFRS.

Interview questions

• Q: When is a preference share a liability rather than equity? A: When the issuer has a contractual obligation to deliver cash - mandatory redemption, a holder's put option, or a non-discretionary cumulative dividend; then the dividend is a finance cost.
• Q: How do you split a convertible debenture? A: Measure the liability first as the present value of contractual cash flows at the market rate for similar debt without the conversion feature; the balance of proceeds is the equity component, which is never remeasured.
• Q: What are the two tests for classifying a financial asset? A: The business model test (hold to collect, hold to collect and sell, or other) and the contractual cash flow or SPPI test; both together give amortised cost, FVOCI or FVTPL.
• Q: Difference between FVOCI for debt and FVOCI for equity? A: Debt FVOCI runs EIR interest and ECL through P&L and recycles the cumulative OCI on sale; equity FVOCI is an irrevocable election with no impairment and no recycling - only dividends reach P&L.
• Q: Why is an allowance recognised on a loan the day it is given? A: Because Ind AS 109 is an expected-loss model - 12-month ECL is recognised at origination without any loss event, unlike the earlier incurred-loss approach.
• Q: What triggers a move from Stage 1 to Stage 2? A: A significant increase in credit risk since initial recognition, with a rebuttable presumption once an account is more than 30 days past due; the allowance becomes lifetime ECL.
• Q: How does interest recognition change in Stage 3? A: Interest is computed on the net carrying amount (gross less loss allowance) using the original EIR, instead of on the gross amount.
• Q: What is the 10% test? A: On modifying a financial liability, if the PV of revised cash flows discounted at the original EIR differs by 10% or more from the existing carrying amount, the old liability is extinguished and a new one recognised at fair value.
• Q: Can an entity apply hedge accounting to a position it economically hedged last month? A: No - designation and documentation must exist at inception of the hedge; hedge accounting is prospective and cannot be applied retrospectively.
• Q: Where does the ineffective portion of a cash flow hedge go? A: Straight to profit or loss; only the effective portion, the lower of the cumulative derivative gain/loss and the cumulative change in hedged cash flows, sits in the cash flow hedge reserve.
• Q: Is a loan given to a subsidiary at nil interest a financial asset at face value? A: No - it is recognised at fair value, so a below-market interest-free loan is discounted, with the difference treated as an investment in the subsidiary or an expense depending on the facts.
• Q: Why are advance to a vendor and GST receivable not financial assets? A: They give a right to goods or services, or arise from statute, not a contractual right to receive cash or another financial asset.

Common mistakes

• Classifying redeemable preference shares as equity and showing the dividend as an appropriation instead of finance cost.
• Discounting the liability component of a convertible instrument at the coupon rate instead of the market rate for similar non-convertible debt, or remeasuring the equity component later.
• Expensing transaction costs on an amortised cost asset or liability instead of folding them into the carrying amount and the EIR.
• Applying ECL to equity investments or to FVTPL assets, which are outside the impairment scope.
• Using only historical loss rates in a provision matrix with no forward-looking adjustment, and failing to discount long-dated ECL at the original EIR.
• Claiming hedge accounting without contemporaneous documentation, or still quoting the IAS 39 80-125% effectiveness band.
• Offsetting a payable against a receivable with the same party on the strength of a right of set-off alone, without the intention to settle net.

Related topics

Company accounts and Ind AS basics · Key Ind AS standards explained · Accounting Standards (AS) for non-Ind AS entities · Consolidated financial statements · Cash flow statement · Ind AS 115 and Ind AS 116: revenue and leases