Introduction to Financial Instruments, Classification of Financial Assets and Liabilities, Embedded Derivatives or Complex Derivatives....

1. Swaminath S
M.Com., PGDFBA, PGDFM, PGDMM, NET & JRF, SLET, (MBA), (Ph.D)
Assistant Professor,
Government First Grade College,
Sakharayapattana, Chikmagalur1
@

2.  Classification of Financial Assets and
Financial Liabilities.
 Recognition, De-recognition and
Measurement of Financial Instruments.
 Compound Financial Instruments and
Accounting for Compound Financial
Instruments.
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3.  During the last few years, a number of new Financial
Instruments have assumed significance in the Indian
Economy.
 Derivatives are a kind of financial instruments whose
values change in response to the change in specified
interest rates, security prices, and commodity prices, index
of prices or rates, or similar variables. Ex: Fo, Fu, Op & Sw
 The Institute of Chartered Accountants of India came out
with the Accounting Standards 30, 31, 32 for
Recognition, Measurement, Presentation and Disclosures
of Financial Instruments. 3

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• A contractual right to receive cash, or to exchange
financial assets or liabilities with other enterprise
under conditions that are potentially favorable to the
enterprise.
• Ex: Cash, Equity Instruments of other enterprise -
Investment in ordinary shares.
Financial
Asset
• Financial Liability is a contractual obligation to
deliver cash or to exchange financial assets or
financial liabilities with another enterprise under
conditions which are potentially unfavorable to
the enterprise.
• Ex: Convertible debenture, convertible Preference
share.
Financial
Liability
Financial Instrument is a contract that gives rise to a Financial asset for one
enterprise and a Financial Liability or an Equity for another enterprise. The
example are investments, debtors, deposits etc.

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• Fixed assets, stock, pre-paid expenses are not financial assets.
• Deferred incomes and warranty obligation are not financial
liabilities.
Note
Held for trading:
Financial assets at
fair value through
Profit & Loss.
Held to maturity:
Assets with fixed
maturity and the
entity has a positive
intention and ability
to hold till maturity.
Loans & Receivables:
Assets with fixed
payments determinable
and which are not quoted
in the market.
Available for sale: Those
assets which are not
classified under the above
3 categories. (residual)

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Financial liability at fair value through
profit & loss (Held for trading liabilities.)
Other Liabilities
Fair value
Amortized
Cost
Available for sale
Loans & receivables
Held to maturity
Held for Trading
*** The only exception
to this rule is equity
instruments that do not
have a quoted market
price in an active market
and whose fair value
cannot be reliably
measured and
derivatives that are
linked to and must be
settled by delivery of
such an unquoted equity
instrument, which are
instead held at cost. ***

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• Trade date accountings & settlement date accounting: A financial
asset purchased or sold is accounted for on trade date is called trade date
accounting if it is accounted for on settlement date then it is called
settlement date accountings.
• Accountings for financial assets at fair value through profit & loss:
(held for trading)
• On the day of acquisition the asset is recognized at fair values.
• The transaction costs are directly charged to the profit & loss account.
(This is also applicable for interim financial statement.)
• On subsequent reporting dates they are measured at fair values. The
difference is transferred to P/L A/c.
• On Disposal the assets will be de-recognized and the difference
carrying amount & fair value at the date of sale is transfer to P/c A/c.
• No impairment test is required.
• Any change in the fair value between trade date & settlement date is
recognized through profit & loss A/c.

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1. Financial assets at fair value through profit or loss
(FVTPL) / Held for Trading:
• FVTPL has two sub-categories.
• Financial Asset – Initial Recognition – Fair Value – P&L A/c –
(except for equity instrument, where it does not have a quoted
market price in an active market for which fair value is reliably
determinable)
• Financial Assets – Held for Trading – All Derivatives – Fair
Value – P&L A/c – (except hedging instruments)
• Held for Trading: acquired or incurred principally for the
purpose of selling or repurchasing it in the near term.
• If a derivative asset is a hedging instrument in a cash flow
hedge or a hedge of a net investment in a foreign operation,
part of the fair value gains/losses will be recognized initially in
equity, later in P&L A/c)

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1. Financial assets at fair value through profit or loss
(FVTPL) / Held for Trading:

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1. Financial assets at fair value through profit or loss
(FVTPL) / Held for Trading:

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2. Available for Sale:
• These are non-derivative financial instruments and are not
classified as:
(a) Loans and receivables,
(b) Held-to-maturity investments, or
(c) Financial assets at fair value through profit or loss.
• Measurement – Fair Value – Gains / Losses recognized directly
in an appropriate equity account. Ex: Investment Revaluation
Reserve Account.
• At the time of de-recognition – cumulative gain or loss
previously recognized in equity is recognized in the statement
of profit and loss for the period.
• Dividends on an available-for-sale equity instrument are
recognized in the statement of profit and loss when the entity’s
right to receive payment is established.

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• On the day of purchase they are measured at acquisition cost
plus directly attributable transaction cost.
• On each subsequent reporting date they are measured at fair
values. The difference is debited or credited to an equity
account – Example: Investment revaluation reserve. (600 - 800
– 320)
• Impairment test is required
• On disposal the balance in investment revaluation reserve will
be transferred to P/L A/c.
2. Available for Sale:

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2. Available for Sale:

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2. Available for Sale:

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3. Loans & Receivables are Non-Derivative
Financial Assets:
• Loans and receivables are non-derivative financial assets
with fixed or determinable payments that are not quoted in
an active market and they are not classified as above
categories.
• Loans and receivables are measured at amortized cost using
the effective interest method.
• Loans and receivables are not subject to the tainting
provisions and impairment test is required.
• Loans and receivables not held for trading can be classified
as such even if an entity does not have the positive intention
and ability to hold them until maturity.
• When there is no active market – amortized cost and firm
doesn’t have any positive intention to keep those instrument.

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4. Held-to-Maturity Investments:
• Held-to-Maturity Investments are non-derivative financial
assets with fixed or determinable payments and fixed
maturity that an entity has the positive intention and ability
to hold to maturity and they are not classified as above
categories.
• Held to maturity investments are measured at amortized cost
using the effective interest rate method.
• On the day of acquisition they are measured at acquisition
cost plus transaction cost.
• On he subsequent reporting date they are measured using
effective interest rate at amortized cost.
• Impairment test is needed.
• On maturity no profit or loss will arise.

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4. Held-to-Maturity Investments:

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• Convertible debenture – within 3 years – option to convert into
equity.
• An embedded derivative is a component of a hybrid instrument
which also includes a non – derivative host contract.
• The hybrid contract is the entire contract, within which there
may be an embedded derivative. The host contract is the main
body of the contract, excluding the embedded derivative.
• Ex: Company X holds a bond which is convertible into the
equity shares of company Y. The hybrid contract is the
convertible bond; the host contract is the bond asset, and the
embedded derivative is the conversion option.
• An embedded derivative should be separated from the host
contract and accounted for as a derivative under this Standard
(AS 30)

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Its an action designated to reduce uncertainty of value of assets, value of
liabilities, cash flows, firm commitments. Ex: portfolios of equity,
foreign currency receivables, foreign currency payables, inventories etc.
Instruments used for hedging are forward, future, option, swaps.
Three Types of Hedging Strategies:
1. Fair Value Hedge – Fair value changes due to a particular risk and
could affect profit or loss. Ex:-
• Fixed rate liabilities like loans;
• Fixed rate assets like investments in bonds;
• Investments in equity securities; and
• Firm commitments to buy/sell non-financial items at a fixed
price.

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2. Cash Flow Hedge – hedge of the exposure to variability in cash
flows; particular risk associated with a recognized asset or liability.
Ex: Swap (LIBOR & MIBOR) – Back to Back Loans
• Variable rate liabilities like loans;
• Variable rate assets like investments in bonds;
• Highly probable future issuance of fixed rate debt;
• Highly probable forecast sales and purchases.
3. Hedge of a Net Investment in a Foreign Operation (‘Net
Investment Hedge’):
The gain or loss on the hedging instrument relating to the effective
portion of the hedge that has been recognized directly in the equity
account should be recognized in the statement of profit and loss on
disposal of the foreign operation.

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