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Financial Instruments

What is a financial instrument-1?
It can be a financial liability or an equity instrument
If it is an equity instrument then :
A) it does not any contractual obligations (deliver cash
or exchange asset / liability)
B) it is either a non derivative (with no contractual
obligations) alternatively
C) if it is a derivative then it is to be settled in either
cash or by an asset for a fixed number of the entitys
own equity instruments
What is a financial instrument-2?
When an entity is obligated to buy back its own shares
(treasury shares) a liability exists
In a situation where an entity can exchange its own
equity instruments to receive or deliver shares ( with a
fixed amount) then this arrangement / contract is not
an equity instrument but a financial asset or a
financial liability
What is a financial instrument-3?
An instrument that gives right to the holder to sell it to
the issuer for either cash or another financial asset is a
liability to the issuer
An instrument is a liability when settlement depends
on some uncertain events
A derivative financial instrument is either an asset or a
liability when there is a choice for settlement.
What is a financial instrument-4?
While measuring a financial instrument, the asset and
liability components are first separated & then the
residual is considered as equity component.
Treasury shares- when an entity acquires or resells its
own shares, this transaction represents a change of
ownership and consequently no gain or loss arises.
The treasury share transaction costs are equity related
and are deducted from equity.
Scope within IAS 32- 1
This standard is applicable to all financial instruments
Subsidiaries, joint ventures, associates etc.
Employees benefits
Insurance contracts. However, where such contracts
are embedded derivatives (IAS 39) then apply IFRS 4
(recognition and measurement of financial
Instruments where share based payments are involved,
apply IFRS 2
Scope within IAS 32- 2
The standard applies to contracts to buy or sell non
financial instruments which can be settled in cash by some
other financial instruments
When settlement can be in cash / other financial
instruments then watch for these: a) the contracts demand
this type of settlements, b) when contract is not explicit
then the traditional settlements like cash or other
instruments will be in order, c) when it is the usual practice
of the entity to quickly buy/sell to make short term gains or
When a contract is readily convertible in cash
A written option that can be settled in cash, cannot be
settled in any other way.
Definitions- 1
A financial instrument is a contract that gives rise to a
financial asset and a liability in two different entities
A financial asset is cash, equities in another entity, a
contractual right to receive cash or exchange with
another asset or liability that is potentially favorable to
the entity.
A financial asset is also a contract that may be settled
by the entitys own equity if it is a non derivative. If it
is a derivative, then it may be settled for either cash or
another asset. An entitys own equity instruments will
not be included in these transactions.
Definitions- 2
A financial liability can be a contractual obligation to
deliver cash or another asset or exchange financial
assets / liabilities under unfavorable conditions to the
A liability can also be a contract which can be settled
with the entitys own equity instrument which is when
a non derivative can be settled by a certain number of
the entitys own equity instrument and if a derivative
then settlement can be by means other than cash
Definitions- 3
An equity instrument is a contract that has a residual
interest after deducting all liabilities
Fair value could be defined as a value that could be
exchanged or liabilities settled between settled between
willing and knowledgeable parties in an arms length
A puttable instrument is sellable for cash or any other
financial asset or it is automatically transferred to the
issuers on the occurrence of an uncertain event.
Contracts usually have clear economic consequences and
the related parties have little discretionary power to avoid.
Entities include individuals, partnerships, incorporated
bodies etc.
The issuer of a financial instrument will classify the
instrument either as an asset or an equity instrument,
Under certain conditions, an issuer will define an equity
instrument if it has no contractual obligations to deliver
cash or financial asset of another entity or to exchange any
assets / liabilities under unfavorable conditions. If the
instrument is to be settled with the issuers own equity
instrument then if it is a non-derivative that includes no
contractual obligations to deliver the entitys own equity or
if it is a derivative that would require settlement with a
fixed amount of cash or a fixed number of shares of the
Puttable instruments
These include contractual obligations for the issuer to
repurchase or redeem instruments for cash or another financial
asset when sold.
What is an equity instrument?- if an instrument entitles the
holder to a pro-rata share after payment of all liabilities on
liquidation. A pro-rata share is determined on dividing an
entitys assets into equal units of amounts and multiply the units
held by the holder with the unit amount. The instrument is
subordinate to all other instruments. A subordinate instrument
has no priority over other claims to the assets. All subordinate
instruments are puttable and the formula to calculate the
redemption price is the same in that class.
Puttable instruments do not have any obligations apart from the
contractual obligations by the issuer.
Obligations on liquidation
Some financial instruments hold conditions to transfer
pro rata share of net assets to the holder on
liquidation. Obligation arises when it is beyond
control of the entity or it is uncertain to occur.
An equity instrument has features such as the holder is
entitled to pro rata share on liquidation. The share is
determined by unit rates multiplied by the number of
units held. These are subordinate instruments. All
subordinate instruments have identical obligations.

Reclassification of puttable
An entity will reclassify a financial instrument as an
equity instrument when it has all the necessary
features. Reclassification will be done when an equity
instrument ceases to have the specific features. The
difference between the carrying amount of an equity
instrument and the fair value of a financial instrument
will be recognized in equity at the date of
reclassification. To reclassify a financial liability as
equity when it has all the requisite features. It is to be
re-measured at carrying value at reclassification.
Absence of contractual obligations
With some exceptions, a financial liability differs from
equity as it has contractual liabilities to deliver either
cash or another financial asset. Substance rather the
legal form governs the financial liabilitys
classification. Such as a preference share has a
mandatory financial liability for redemption. When a
holder of a financial instrument has the right to sell it
back to the issuer for cash or another financial asset
then it is a financial liability. If an entity does not have
the right to avoid a liability by payment of cash or
another asset then the obligation is a financial liability.
Settlement with the entitys own
Even if it is contractual to settle an instrument with an
entitys own shares, this situation does not necessarily
make it an equity instrument.
In a settlement, if an entity receives its own shares,
then it is financial asset or a financial liability contract.
It is a financial liability when the entity has to buy
back its own shares for cash.
A contract that requires delivery of an entitys own
shares in exchange for cash or another asset is a
financial asset or a financial liability.
Contingent settlement provisions
A contingent settlement requires a financial
instrument to deliver cash or another financial asset
on the happening of a certain event in future which
will render the instrument as a financial liability. Such
events are beyond control of an entity.
Settlement options
When an instrument holder has a choice of settlement
such as by net cash or by exchanging shares then the
instrument is either a financial asset or a financial
liability unless all the settlement alternatives point to
the instrument being an equity instrument.
Financial instruments are either settled in cash or by
exchanging shares. These are not equity instruments.
Compound financial instruments
The issuer of a non derivative financial instrument will
examine the terms to determine whether the
instrument contains both liability and equity elements
in which case such different components will be
separately displayed.
The instrument holders may have the option to
convert financial instruments into equity ones at a
later date. Example: convertible bonds converted into a
fixed number of ordinary shares.
Treasury shares
If an entity acquires its own shares or equity
instruments then these are termed as treasury shares
and these are then deducted from entitys
shareholders equity.
No gain or loss arise on an entitys own equity
All the treasury share related payments and receipts
are accounted for under equity.
The details of all the treasury shares held are to be
disclosed in the financial statements.

Interest, dividends, gains and
Interests, dividends, gains and losses relating to a financial instrument
or a component that is a financial liability, shall be recognized in the
profit and loss accounts.
Any dividend distributions to holders of financial instruments along
with any transaction costs shall be directly debited to equity net of any
income tax benefits.
The classification of any instrument such as whether it is a financial
liability or an equity instrument will determine whether the related
costs such as interests etc. will be recognized in the profit and loss.
The issue costs of equities should be deducted from equity. These costs
are typically legal, accounting etc.
If dividends are classified as an expense then they should be presented
in the statement of comprehensive income.
The requirements of IAS 1 and IFRS 7 are to be complied with.

Offsetting a financial asset and a
financial liability
a financial asset and a financial liability shall be offset and
the net amount shall be presented in the financial
statements under the following circumstances:
A) there is a legal enforceable right of setoff
B) the entity wants to settle on a net basis or wants to
realize asset and settle liability simultaneously
When transfer of an asset does not qualify for de-
recognition, asset and liability set offs do not take place.
This standard requires a set off when doing so presents the
future cash flows after settling two or three instruments.
Net presentation has to reflect more meaningful expected
cash flows.
Offsetting a financial asset and a
financial liability (continued)
Offsetting assets with liabilities is generally inappropriate
A) several instruments are used to emulate one instrument
B) financial assets and liabilities have the same primary
risk exposure (example: assets and liabilities of a portfolio
involve different counterparties)
C) financial assets are pledged
D) assets are set aside in trust
E) obligations arising under an insurance contract
An entity may enter into a multiple instrumental
transaction with a single counterparty with a master
netting arrangement.

Sundry points
1. The effective date of application of the standard is 1

January 2005
2. Puttable financial instruments with regards to an
entity should apply amendments as per IAS 32 and
IAS 1.
3. Puttable financial instruments and obligations
arising on liquidation have a limited scope exception
not applicable to all entities
4. The standard should be applied retrospectively