AS 30, 31, & 32 – FINANCIAL INSTRUMENTS :
Applicability of AS 30, 31 and 32
These standards are not mandatory but earlier adoption is encouraged. It may be mentioned that it has not been adopted by NACAS and thus in case of a company an earlier adoption of these standards might not comply with certain standards like
AS-13 investment: A Company needs to consult accounting experts in such situation. Needless to mention that in case the company wishes to adopt the standard than it shall adopt the entire standard and not a part of it.
ICAI Clarification – Principle of Prudence
Under situation where an item of financial instrument is suffering from losses, than based on principle of prudence the entity shall provide for such losses through its profit and loss account.
Objectives and scope
Financial instruments are addressed in three standards: AS-31, which deals with distinguishing debt from equity and with netting; AS 30, which contains requirements for recognition and measurement; and AS-32, which deals with disclosures. The objective of the three standards is to establish requirements for all aspects of accounting for financial instruments, including distinguishing debt from equity, netting, recognition, derecognition, measurement, hedge accounting and disclosure. The scope of the standards is wide-ranging. The standards cover all types of financial instrument, including receivables, payables, investments in bonds and shares, borrowings and derivatives. They also apply to certain contracts to buy or sell non-financial assets (such as commodities) that can be net settled in cash or another financial instrument.
Nature and characteristics of financial instruments
Financial instruments include a wide range of assets and liabilities. They can mostly be exchanged for cash. They are recognised and measured according to AS-30 requirements and are disclosed in accordance with AS- 32. Financial instruments represent contractual rights or obligations to receive or pay cash or other financial asset. A financial asset is cash; a contractual right to receive cash or another financial asset; a contractual right to exchange financial assets or liabilities with another entity under conditions that are potentially favourable; or an equity instrument of another entity. A financial liability is a contractual obligation to deliver cash or another financial asset or to exchange financial instruments with another entity under conditions that are potentially unfavourable. An equity instrument is any contract that evidences a residual interest in the entity’s assets after deducting all its liabilities. A derivative is a financial instrument that derives its value from an underlying price or index, requires little or no initial investment and is settled at a future date. In some cases contracts to receive or deliver a company’s own equity can also be derivatives.
Embedded derivatives in host contracts
Some financial instruments and other contracts combine, in a single contract, both a derivative element and a non-derivative element. The derivative part of the contract is referred to as an ‘embedded derivative’ and its effect is that some of the cash flows of the contract will vary in a similar way to a standalone derivative. For example, the principal amount of a bond may vary with changes in a stock market index. In this case, the embedded derivative is an equity derivative on the relevant stock market index.
Embedded derivatives that are not ‘closely related’ to the rest of the contract are separated and accounted for as if they were stand-alone derivatives (i.e., measured at fair value, generally with changes in fair value recognised in profit or loss). An embedded derivative is not closely related if its economic characteristics and risks are different from those of the rest of the contract. AS-30 sets out examples to help determine when this test is (and is not) met. Analysing contracts for potential embedded derivatives and accounting for them is one of the more challenging aspects of AS-30.
Classification of financial instruments
The way that financial instruments are classified under AS-30 drives how they are subsequently measured and where changes in measurement are accounted for.
There are four classes of financial asset under AS-30: available for sale, held to maturity, loans and receivables, and fair value through profit or loss. The factors taken into account in classifying financial assets include:
– The cashflows arising from the instrument — are they fixed or determinable? Does the instrument have a maturity date?
– Are the assets held for trading; does management intend to hold the instruments to maturity?
– Is the instrument a derivative or does it contain an embedded derivative?
– Is the instrument quoted on an active market?
– Has management designated the instrument into a particular classification at inception?
Financial liabilities are classified as fair value through profit or loss if they are so designated (subject to various conditions) or if they are held for trading. Otherwise they are classed as ‘other liabilities’. Financial assets and liabilities are measured either at fair value or at amortised cost, depending on this classification. Changes are taken to either the income statement or directly to equity. Financial liabilities and equity
The classification of a financial instrument by the issuer as either a liability (debt) or equity can have a significant impact on an entity’s reported earnings, its borrowing capacity, and debt-to-equity and other ratios that could affect the entity’s debt covenants. The substance of the contractual arrangements of a financial instrument, rather than its legal form, governs its classification. This means, for example, that since a preference share redeemable (puttable) by the holder is economically the same as a bond, it is accounted for in the same way as the bond. Therefore, the redeemable preference share is treated as a liability rather than equity, even though legally it is a share of the issuer. The critical feature of debt is that under the terms of the instrument the issuer is, or can be, required to deliver either cash or another financial asset to the holder and cannot avoid this obligation. For example, a debenture, under which the issuer is required to make interest payments and redeem the debenture for cash, is a financial liability. An instrument is classified as equity when it represents a residual interest in the issuer’s assets after deducting all its liabilities. Ordinary shares or common stock, where all the payments are at the discretion of the issuer, are examples of equity of the issuer. A special exception exists to the general principal of classification for certain subordinated redeemable (puttable) instruments that participate in the pro rata net assets of the entity. Where specific criteria are met such instruments would be classified as equity of the issuer. Some instruments contain features of both debt and equity. For these instruments, an analysis of the terms of each instrument in light of the detailed classification requirements will be necessary. Such instruments, such as bonds that are convertible into a fixed number of equity shares either mandatorily or at the holder’s option, must be split into debt and equity (being the option to convert) components. A financial instrument, including a derivative, is not an equity instrument solely because it may result in the receipt or delivery of the entity’s own equity instruments. The classification of contracts that will or may be settled in the entity’s own equity instruments is dependent on whether there is variability in either the number of own equity delivered and/or variability in the amount of cash or other financial assets received, or whether both are fixed. The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument. So, if a preference share is classified as debt, its coupon is shown as interest. But the dividend payments on an instrument that is treated as equity are shown as a distribution.