Ind AS-7 : Cash Flow Statement

Chapter 12 Unit 1: Ind AS 32: Financial Instruments (Presentation) 809

The entire definition of ‘financial liability’ has been set up as under in Paragraph 11 of Ind AS 32:

Definition of Financial Liability

Point (a)

Clause (i) Clause (ii)

To deliver cash/another Financial Asset

Exchange under conditions potentially unfavourable Clause (i)

NonDerivative

Failure of 'Fixed Test' Point (b)

Clause (ii)

Derivative

Failure of 'Fixed for Fixed Test' Clarifications:

Clarification I

Rights, option, warrants

Clarification II (Carve out)

FCCB (Foreign currency convertible bonds)

Clarification III

Equity Instruments not to include 'Deemed Equity Instruments'

Aspect 1:

Any Liability: It will include:

1. Actual liability. 2. Contingent liability. (Though there is Ind AS 37 dealing with the same; See discussion in scope later for more understanding) 3. Derivative liability. 4. Non-derivative liability.

Aspect 2:

Contractual obligation:

There has to be an obligation which is contractual in nature.

For example:

Income tax to be paid to government is an obligation but not contractual in nature. It is statutory in nature; therefore, would not be a financial liability.

Aspect 3: Ways in which the contractual obligation is discharged:

Note:

Not all ways have been discussed at this stage.

1. Point (a)(i) of the definition:

Cash (includes through bank and cash and cash equivalents) or another Financial Asset

2. Point (b)(i) of the definition:

Own equity instruments (but variable in number)

Special Issues: (Discussed separately)

Point (a) (ii) – Exchange Point (b) (ii) - Derivative

Ind AS 32 recognizes the use of own equity instruments as a medium of settlement of an obligation.

This concept is called in case of non-derivative “Fixed Test”.

In simple words,

If an entity issues Fixed no. of equity instruments it passes the Fixed Test and the instrument is not a financial liability in that case.

If an entity issues Variable no. of equity instruments it fails the Fixed Test and the instrument is a financial liability in that case.

Let us put the above discussion in the form of a step chart to make our thought process clear.

Step 1: Is there a contractual obligation?

Yes

Go to Step 2 No

Stop

Step 2: How will the contractual obligation be discharged?

Cash/Bank/Cash and Cash equivalents/Another Financial Asset

Equity Instruments

Financial Liability Variable No.

Financial Liability Fixed No.

Not a Financial Liability

Chapter 12 Unit 1: Ind AS 32: Financial Instruments (Presentation) 811

Let us take some examples to make the above concept absolutely clear especially when we use own equity instruments as a medium for settlement.

Example 2:

X Ltd. issues convertible debentures to Y Ltd. for a subscription amount of Rs. 250 crores. Those debentures are convertible after 5 years into equity shares of X 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.

Answer:

Such a contract is a financial liability of the entity where the entity is using own equity instruments as a medium (currency) to settle the transaction. It is not an equity instrument because the entity uses a variable number of its own equity instruments as a means to settle the contract.

(It fails the Fixed Test)

Example 3:

A Ltd., issues convertible debentures to B Ltd. for a subscription amount of Rs. 340 crores. Those debentures are convertible after 5 years into 40 crore equity shares of Rs. 10 each.

Examine the nature of the financial instrument. Answer:

This contract is an equity instrument because number of equity instruments to be received or delivered is

fixed. (It passes the Fixed Test)

Test your knowledge:

A Ltd. took a borrowing from Z Ltd. for Rs. 20,00,000. Z Ltd. enters into an arrangement with A Ltd. for settlement of the loan against issue of a certain number of equity shares of A Ltd. whose value equals Rs. 20,00,000. For this purpose, fair value per share (to determine total number of equity shares to be issued) shall be determined based on the market price of the shares of A Ltd. at a future date, upon settlement of the contract.

Evaluate the nature of financial instrument? Answer:

A Ltd. is under an obligation to issue variable number of Equity shares equal to a total consideration of Rs. 20,00,000. Hence, equity shares are used as currency for purpose of settlement of an amount payable by A Ltd. Since this is variable number of shares are to be issued in a non-derivative contract, it implies the use of equity shares as ‘currency’ and hence, this contract meets definition of financial liability in books of A Ltd.

(It fails the Fixed Test)

Special Issue 1:

Exchange:

Point (a) (ii):

“To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity”

Example 4:

P Ltd. takes a short position in a call option with A Ltd. (long position) to subscribe to P Ltd.’s equity shares at a price of Rs. 200 per share. The call option is to be settled on a ‘net’ basis i.e. without physical delivery of shares.

Analysis:

If on the balance sheet date, market value of equity share of P Ltd. is Rs. 210 per share, P Ltd. will be obliged to pay Rs. 10 to settle the option. Such a condition is potentially unfavourable to P Ltd. and hence Rs. 10 represents a financial liability for P Ltd.

Special Issue 2:

Derivative:

Point (b) (ii):

“A derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.” Look at the italicized words carefully. You can see the words – Fixed for Fixed.

This concept is called in case of derivative “Fixed for Fixed Test”. In simple words,

Fixed Consideration Fixed No. of Equity Instruments to be issued in settlement Fixed for Fixed Test

Example 5:

S Ltd. purchases an option from T Ltd. entitling the holder to subscribe to equity shares of issuer at a fixed exercise price of Rs. 60 per share at any time during a period of 3 months. Holder paid an initial premium of Rs. 5 per option.

Examine how will the financial instrument will be classified?

Answer:

For the issuer A Ltd., this option is an equity instrument as it will be settled by the exchange of a fixed amount of cash for a fixed number of its own equity instruments.

(It passes the Fixed for Fixed Test) We can summarize the concept of both ‘Fixed Test’ and ‘Fixed for Fixed Test’ as under: S. No. Particulars Remarks Logic

1. Non-Derivative Passes Fixed Test Equity Instruments Fixed no. of equity instruments is being issued. 2. Non-Derivative Fails Fixed Test Financial Liability Variable no. of equity instruments is being issued. 3. Derivative Passes Fixed for Fixed Test Equity Instruments Issuer does not have an obligation to pay cash. Holder is not exposed to variability.

S. No. Particulars

4. Derivative Passes Fixed for Variable Test

5. Derivative Passes Variable for Fixed Test

6. Derivative Passes Variable for Variable Test

Remarks Logic

Financial Liability Own variable equity instruments are used to settle obligation for fixed amount. Financial Liability Issuer does not have an obligation to pay cash. Holder is exposed to variability. Financial Liability Both parties (issuer and holder) are exposed to variability.

Aspect 4:

Rights, options or warrants:

Point (b) (ii):

‘Rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments.’

Aspect 5:

Equity conversion option embedded in a convertible bond denominated in foreign currency (simply called FCCB):

Point (b) (ii):

‘Equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in

any currency.’

The position in Ind AS is different from IFRS. Let us pin point the Carve-out on this issue:

As per IFRS (i.e. IAS 32):

As per accounting treatment prescribed under IAS 32: Equity conversion option In case of foreign currency denominated convertible bonds (FCCBs) Is considered a derivative liability which is embedded in the bond

Gains or losses arising on account of change in fair value of the derivative need to be recognised in the

Statement of profit and loss as per IAS 32.

Carve out (Based on Ind AS 32):

In Ind AS 32, an exception has been included to the definition of “Financial liability in Paragraph 11(b) (ii), whereby: Conversion option In a convertible bond denominated o In foreign currency To acquire a fixed number of entity’s own equity instruments Is classified as an equity instrument o If the exercise price is fixed in any currency

Reasons for the carve-out:

The treatment as per IAS 32 is not appropriate in instruments, such as, FCCB’s since the number of

814 Unit 1: Ind AS 32: Financial Instruments (Presentation) Chapter 12 shares convertible on the exercise of the option remains fixed and the amount at which the option is to be exercised in terms of foreign currency is also fixed; (Merely the difference in the currency should not affect the nature of derivative, i.e., the option.)

Further, the fair value of the option is based on the fair value of the share prices of the company. If there is decrease in the share price, the fair value of derivative liability would also decrease which would result in recognition of gain in the statement of profit and loss.

This would bring unintended volatility in the statement of profit and loss due to volatility in share

prices.

This will also not give a true and fair view of the liability as in this situation, when the share prices fall, the option will not be exercised.

However, it has been considered that if such option is classified as equity, fair value changes would not be required to be recognised.

Accordingly, the exception has been made in definition of financial liability in Ind AS 32.

Example 6:

Entity A issues a bond with face value of USD 1000 and carrying a fixed coupon rate of 6% p.a. Each bond is convertible into 10,000 equity shares of the issuer.

Examine the nature of the financial instrument. Analysis:

While the number of equity shares is fixed, the amount of cash is not. The variability in cash arises on account of fluctuation in exchange rate of INR-USD. Such a foreign currency convertible bond (FCCB) will as per IFRS i.e. IAS 32 qualifies the definition of financial liability. However, Ind AS 32 provides, “the equity conversion option embedded in a convertible bond denominated in foreign currency to acquire a fixed number of the entity’s own equity instruments is an equity instrument if the exercise price is fixed in any currency.” Accordingly, FCCB will be treated as an equity instrument.

Aspect 6:

Entity’s own equity instruments do not include….

Point (b) (ii):

‘Also, for these purposes the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.’

Ind AS 32 in the definition of Financial liability gives us 3 instruments which are not considered as equity instruments for settlement of financial liability; though they are regarded as “deemed equity instruments” (see Aspect 7 below).

1. Puttable financial instruments.

(Classified as equity instruments if all conditions of paragraphs 16A and 16B are met – Discussed in detail later.)

2. Instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation.

(Classified as equity instruments if all conditions of paragraphs 16C and 16D are met – Discussed in detail later.)

3. Instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments.

Aspect 7:

Exception: (Clarification at the end of the definition)

“As an exception, an instrument that meets the definition of a financial liability is classified as an equity instrument if it has all the features and meets the conditions in paragraphs 16A and 16B or paragraphs 16C and 16D.”

These are technically called “Deemed equity instruments”. (Discussed in detail later)

They are ‘Financial liabilities’ but treated as ‘Equity Instruments’ if certain conditions are met. At this stage we can only keep one simple concept in mind.

Case I:

Case II:

Financial Liability

All conditions of Paragraphs 16A & 16B are met

Financial Liability

Deemed Equity Instruments

All conditions of Paragraphs 16C & 16D are met Deemed Equity Instruments

Let’s recall; These equity instruments are not considered as equity instruments for settlement of Financial Liability. See Aspect 6 above.

816 Unit 1: Ind AS 32: Financial Instruments (Presentation) Chapter 12

Though we are yet to see the definition of ‘Equity Instruments’ but we can create a super summary chart covering major aspects we have discussed above.

Step 1: Is there a contractual obligation?

Yes

Step 2: Is there an obligation to deliver cash or another financial asset?

No

Not a Financial Instrument (apply applicable Ind AS )

Yes

Financial Liability No

Step 3: Is there an obligation to exchange financial assets or liabilities under potentially unfavourable conditions ?

Yes

Financial Liability No

Step 4: Is there an obligation to issue own equity instruments AND Either of the consideration received/receivable or number of equity instruments is VARIABLE

Yes No

# No means: (a) Obligation to issue own equity instruments.

AND

Financial Liability

Equity Instruments #