By : CA Mehul Shah AS – 30, 31 and 32 Financial instruments

Applicability AS – 30, AS -31 and AS -32 will be applicable to all commercial, industrial and business entities Other than small ; and medium sized entities (SMEs ) It will be recommendatory for initial period of two years starting on or after It will become mandatory for the accounting period commencing on or after

General meaning ?? Financial instruments includes wide spectrum of assets and liabilities of entities and contrary to popular impression is not limited to investments or merely capital market instruments.

AS -13 and AS – 30 redundant ?? From the date AS -30, 31 and 32 becoming mandatory, AS – 13 shall be withdrawn except to the extent it related to accounting for Investment properties.

A contract that gives rise to: and in one entity in another entity What is a financial instrument ?

Combinations  Convertible debt  Exchangeable debt Derivatives  Forwards / futures  Financial options  Swaps  Caps and collars  Financial guarantees  Letters of credit Primary  Equity instruments  Bonds, loans, borrowings  Receivables / payables (including finance leases)  Deposits of cash Financial Instruments

Financial asset An asset that is: Cash An equity instrument of another entity A contractual right: To receive cash or another financial asset; or To exchange financial assets or financial liabilities under potentially favourable conditions; orunder potentially favourable conditions

A contract that will or may be settled in the entity’s own equity instruments and is: A non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; E.g A contract involving exchange of shares for a value of Rs. 10,000, but no. of shares is decided upon the market price prevailing on a given future date. A derivative for a fixed number of the entity’s own equity instruments that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset. E.g A forward contract for receiving 10,000 shares Financial asset ( cont.. )

Example Peter deposited Rs 5,00,000 in SBI This represents a contractual right of Peter to obtain cash or draw cheque from the bank and Equally it is financial liability for SBI as bank has to pay whenever he wants

Example : Is contract to receive gold bullion a financial asset? Financial instrument has to have contractual right to receive cash or another financial asset Being Realizable or Liquid is not the test of financial instruments Although bullion is highly liquid, it is not a financial instrument as no contractual right to receive cash is inherent in that asset.

Financial liabilities Any liability that is A contractual obligation: to deliver cash or another financial asset to another entity; to exchange financial assets/ liabilities under potentially unfavourable conditions; or

A contract that will or may be settled in the entity’s own equity instruments and is: 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 e.g Convertible debentures A derivative for a fixed number of the entity’s own equity instruments and settlement is by way other than by the exchange of a fixed amount of cash or another financial asset. E.g ESOP Financial liabilities ( cont.. )

Example : Own equity shares - non derivative L Ltd sold goods to M Ltd. For Rs. 10 lacs on credit. The payment will fall due on 31 Dec As per the purchase agreement, M Ltd will issue an adequate number of its own equity shares to settle the obligation. The no. of shares shall be determined by dividing the amount due ( Rs. 10 lacs ) by market price of M Ltd’s shares on December

Example : Own equity shares - non derivative Answers : M Ltd. Should recognise the payment due to L Ltd as a liability, although the obligation will be settled by issue of equity shares. On issue of equity shares, the liability will get extinguished and equity in the books of M Ltd. Will increase by corresponding amount.

Then what if fixed for fixed?? A contract that will be settled by the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument.

Equity Instruments Any contract that evidences a residual interest in the net assets of an entity Examples Equity shares Preference shares (if certain criteria are met) Warrants Written call options to issue fixed number of equity shares for a fixed price

A contract that gives rise to: and in one entity in another entity What is a financial instrument ?

AS – 31 establishes the principles for distinguishing between Liabilities and equity The substance of the financial instruments rather than its legal form, governs its classification The most important characteristic that differentiates a liability from equity is the existence of an obligation in the hands of issuer to deliver cash or other financial assets to the holder.

Preference shares : Equity or liability ? Preference shares that are redeemable are to be treated as liability. Preference shares with a PUT option in the hands of the holder is also a liability for the issuer,because once the option is exercised the issuer does not have an unconditional right of refusal to delver cash or other financial asset Preference shares that are not redeemable are equity ( but as per provisions of Companies Act, preference shares are always redeemable, so in Indian context, Preference shares shall always be accounted as liability

Example : exchange financial assets or financial liabilities under conditions that are potentially favourable to the entity Buy Reliance Call Rs at premium of Rs. 20

Scope The financial instruments which are ouside the scope of AS – 30 are Obligation arising under insuarance contracts Interest in subsidiaries Interest in associates Interest in joint ventures Employee benefit plans Right and obligation under lease

Categories of financial assets Financial Assets at fair value through P/LHeld to maturity investmentsLoans and receivablesAvailable for sale FAs

At fair value through profit or loss (FVTPL) Comprises the following two sub-categories: 1)Assets classified as ‘held-for-trading’ because these are: acquired principally for selling in the near term; or part of a portfolio of identified financial instruments for which there is recent actual pattern of short-term profit- taking; or a derivative (except for a derivative that is a financial guarantee contract or a hedging instrument 2)Assets designated as such from initial measurement

Derivatives are always categorized as held for trading unless they are accounted for hedges

Held till maturity ( HTM instruments ) Non-derivative financial assets with three essential characteristics Fixed or determinable payments; Fixed maturity; and Entity’s positive intention and ability to hold to maturity Does not include assets Designated as at FVTPL upon initial recognition Designated as Available-for-sale Which meet the definition of loans and receivables

Identify HTM items 1. Can equity instruments be classified as “HTM” No as there is no fixed term and determinable amount of repayment 2.Can a perpetual debt instrument that offers regular interest service be HTM No, as there is no maturity date

Loans and advances Must be non derivative financial assets with fixed or determinable payments and are not quoted in an active market. They must not be the one held for trading or designated on initial recognition as at carried at FV thro’ P/L They must not be the one initially recognised as AFS items The issuer must have classified them as liabilities rather than equity

Example : Can a Debt instrument with put option be under HTM 6 year 10% debentures with put option after 1 year were purchased, put premium being 2%. Repayment amount varies up on exercising the option, depending up on the time of exercise. Investing company has classified it as HTM and valued at amortized cost. Instrument is quoted and traded. Auditors are of the view that it has to be under loans and receivables. Comment Paying for a put option, contradicts the intention to hold till maturity. So it can not be HTM. When traded in an active market it can not be under loans and receivables. So it has to be under AFS and be valued at Fair value.

Available for sale Non-derivative financial assets Designated as available for sale; or Not classified under any other category, viz. loans and receivables, held-to-maturity investments, or financial assets at fair value through profit or loss Residuary category Does not mean that these financial assets will be sold

Classification of Financial Assets: Decision Tree Held for short term profit taking? Designated as “at fair value thru P/L”? Designated as available- for-sale? Has fixed or determinable payments? Active market exists? Has fixed maturity date? Have intention and ability to hold to maturity and not subject to tainting rule? Held to maturity date Available-for-sale investment At fair value thru P&L Held for trading Loans and receivables Y Y Y Y Y Y Y N N N N N N N

Initial Measurement Financial asset or financial liability is initially recognised at fair value Financial assets/ liabilities at fair value thru P&L Held-to-maturity financial asset Financial liabilities other than “at FV thru P/L Loans and receivables Available for sale financial assets plus transaction costs Transaction costs:  are directly attributable to the acquisition/issue of the financial asset/liability  Incurred on purchase are included  that may be incurred on disposal are excluded

Initial measurement - Summary Financial assetInitial measuremen t Transaction cost Fair value through P/LFair valueExpensed Held till maturityFair valueCapitalized Loans and advancesFair valueCapitalized Available for saleFair valueCapitalized

Fair value Fair value (‘FV’)is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

What is fair value for initial measure Transaction price has to be fair value in an arms length transactions Transaction price need not be market quoted price always When difference between transaction price and fair value is marginal, former is deemed fair value There could be transactions in which other considerations have affected the pricing,where fair value and transaction price could be different.

Fair value Hierarchy If not available, cost less impairment loss No active market – Valuation techniques – DCF, Option pricing model Active market – Quoted price

Subsequent measurement Financial assets are subsequently recognised at amortised cost Loans and receivables Held-to-maturity investments at fair value Available-for-sale securities at cost Unquoted equity instrument and related derivatives At fair value thru P&L

Subsequent measurement- Summary Financial assetSubsequent measurement Gain/ Loss treatment Fair value through P/LFair valueTo P/L a/c Held till maturityAmortised costNot applicable Loans and advancesAmortised costNot applicable Available for saleFair valueTo Equity

Financial liabilities At fair value thru P&L Others That arise when a transfer of a financial asset does not qualify for derecognition or is accounted for using the continuing involvement approach Designated upon initial recognition Held for trading

Transaction cost of an equity instrument When an entity issues or buy backs its own shares, it incurs various cost such as registration fees, printing charges, professional fees paid to lawyers, merchant bankers. The costs which are directly attributable to equity transaction and are incremental will be deducted from equity ( net of tax benefits )

Transaction cost of an equity instrument Paid up share Capital Rs. 10,00,000Less : Transaction cost Rs. (40,000) Rs 9,60,000

What are ‘held for trading’ financial liabilities They are derivative liabilities that are not hedging instruments the obligation from short sales financial liabilities from REPO transactions financial liabilities that are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short-term profit-taking