Financial Reporting · Financial Instruments: Scope and Definitions

Financial Instruments: Definitions under Ind AS 32 and Ind AS 109

Updated 5 October 2026 · Fact-checked

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. To classify one, check the contract: if the issuer has an unavoidable obligation to deliver cash or another financial asset, it is a liability; if not, it is equity.

Understand Financial Instruments: Definitions under Ind AS 32 and 109

Start with the idea of a contract. A financial instrument is a contract that creates a financial asset for one party and a financial liability or equity instrument for the other party. Ordinary trade receivables, loans, bonds, shares and derivatives all fit. Items like income tax payable or advances for goods do not, because they arise from statute or from delivery of goods or services, not from a contract to receive or pay financial items.

A financial asset is cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset, or a contractual right to exchange financial instruments on potentially favourable terms. It also includes certain contracts settled in the entity's own equity instruments, where the entity is or may be obliged to receive a variable number of its own shares, or a derivative settled other than by a fixed-for-fixed exchange.

A financial liability is a contractual obligation to deliver cash or another financial asset, or to exchange financial instruments on potentially unfavourable terms. It also includes contracts that will or may be settled in the entity's own equity instruments where the entity must deliver a variable number of its own shares, or a derivative that is not settled by fixed cash for a fixed number of own shares.

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all its liabilities. The key test is substance, not legal form. If the issuer cannot avoid paying cash or another financial asset, the instrument is a liability even if it is called a share. A redeemable preference share with mandatory redemption is a liability. An irredeemable preference share with discretionary dividends is equity.

The other defined terms come from Ind AS 109. A derivative has a value that changes with an underlying variable, needs little or no initial net investment, and is settled at a future date. Amortised cost is the amount at initial recognition, minus principal repayments, plus or minus cumulative amortisation of any difference using the effective interest method, adjusted for any loss allowance. The effective interest rate exactly discounts estimated future cash payments or receipts over the expected life to the gross carrying amount of the asset or the amortised cost of the liability.

Key rules to remember

Financial instrument: Contract → financial asset of one entity + financial liability or equity instrument of another; Needs a contract. Statutory items such as tax payable or GST payable are not financial instruments.
Liability vs equity test: Unavoidable contractual obligation to deliver cash or another financial asset → financial liability; otherwise → equity; Apply to the issuer. Substance prevails over legal form.
Own-equity settled contract: fixed-for-fixed: Fixed amount of cash for a fixed number of own equity instruments → equity; variable number of own shares → liability (or asset); For non-derivatives, a variable number of shares makes it a liability. For derivatives, only fixed-for-fixed settlement qualifies as equity.
Amortised cost: Initial amount − principal repaid ± cumulative amortisation (effective interest method) − loss allowance (financial assets only; not applicable to financial liabilities); Applies to financial assets. For liabilities there is no loss allowance.
Effective interest working: Interest expense = Opening amortised cost × EIR; Closing = Opening + Interest − Cash paid; Transaction costs are included in the EIR calculation.
Derivative features: Value changes with underlying + little or no initial net investment + settled at a future date; All three conditions must be met.

How to solve Financial Instruments: Definitions under Ind AS 32 and 109 questions

Use this sequence for any question asking you to classify an item or decide if it is a liability or equity.

1Check whether a contract exists. If the right or obligation arises from law, such as tax or statutory dues, or from non-financial items like advances for goods, stop: it is not a financial instrument.
2Identify the issuer (holder's view gives an asset, issuer's view gives a liability or equity). Always classify from the issuer's side for liability vs equity.
3Ask whether the issuer has an unavoidable contractual obligation to pay cash or another financial asset, for example mandatory redemption or fixed compulsory dividends.
4Look for obligations the issuer cannot control: redemption at the holder's option, or settlement triggered by events outside the issuer's control. These point to a liability.
5If settlement is in the issuer's own shares, apply the fixed-for-fixed test: a fixed number of shares for fixed consideration means equity; a variable number means liability.
6Check for mixed features. If both liability and equity components exist, treat the instrument as compound and split it.
7State the conclusion with the reason, citing the definition, and give the measurement consequence if the question asks for it.

Quickest way: Obligation test in 30 seconds

When to use it: Use in MCQs and short classification questions where you must decide asset, liability or equity quickly.

Ask: can the issuer avoid paying cash or another financial asset?
If no, mark it as a liability.
If yes, check whether it settles in own shares; fixed number for fixed amount means equity, variable means liability.
If both an obligation and a discretionary part exist, mark it compound.
Check if it is statutory or non-contractual; if so, it is outside financial instruments.

Common mistakes in Financial Instruments: Definitions under Ind AS 32 and 109

Calling every item labelled 'share' equity, such as mandatorily redeemable preference shares.
Students follow legal form and the Companies Act label.
Fix: Apply the obligation test. Mandatory redemption or fixed compulsory dividends make it a financial liability.
Treating income tax payable or GST payable as a financial liability.
It looks like a payable to a third party.
Fix: These arise from statute, not contract, so they are not financial liabilities under Ind AS 32.
Treating advances received for goods or prepaid expenses as financial instruments.
Cash is involved.
Fix: The settlement is by delivering goods or services, not cash or a financial asset, so they are non-financial.
Classifying a contract to issue a variable number of own shares as equity.
Students think any contract settled in own shares is equity.
Fix: Only fixed-for-fixed settlement gives equity. A variable number of shares makes it a liability.
Classifying from the holder's side when asked about the issuer.
The same contract is an asset for one party and a liability for the other.
Fix: Write down who the issuer is first and classify from that party's viewpoint.
Forgetting that amortised cost uses the effective interest rate and not the coupon rate.
Coupon is visible in the question while EIR needs computation.
Fix: Compute interest on opening amortised cost at the EIR; the coupon is only the cash paid.

Worked examples

Example 1

X Ltd issues 1,00,000 preference shares of ₹100 each. The shares carry a fixed 8% dividend, payable every year, and must be redeemed at par after 5 years. Another series, 50,000 preference shares of ₹100 each, is irredeemable and carries dividends only if the board declares them. How should X Ltd classify each series in its books?

Show the solution

Series 1: the company must pay a fixed dividend each year and must redeem at par. It cannot avoid delivering cash.
This is an unavoidable contractual obligation, so the definition of financial liability is met. The legal form of a share does not change this.
Series 1 amount: 1,00,000 × ₹100 = ₹1,00,00,000, recognised as a financial liability. Dividends are treated as interest expense.
Series 2: there is no obligation to redeem and no obligation to pay dividends, as these are discretionary.
With no obligation to deliver cash, the instrument shows a residual interest, so it is an equity instrument. Amount: 50,000 × ₹100 = ₹50,00,000.

Answer: Series 1 (₹1,00,00,000) is a financial liability, with dividends as finance cost. Series 2 (₹50,00,000) is equity.

Example 2

Y Ltd issues a ₹10,00,000 debenture. Interest is 5% a year, paid annually in arrears, and the debenture is repayable at par after 3 years. Issue costs are nil and the effective interest rate is 8%. The initial fair value is ₹9,22,687 (PV of the cash flows at 8%). Compute the amortised cost at the end of Year 1 and Year 2, and state the classification of the issuer's instrument.

Show the solution

Classification: Y Ltd must pay interest and repay principal in cash, so this is a financial liability.
Year 1 interest expense = ₹9,22,687 × 8% = ₹73,815 (rounded).
Cash interest paid = ₹10,00,000 × 5% = ₹50,000.
Closing amortised cost, Year 1 = 9,22,687 + 73,815 − 50,000 = ₹9,46,502.
Year 2 interest expense = ₹9,46,502 × 8% = ₹75,720 (rounded).
Closing amortised cost, Year 2 = 9,46,502 + 75,720 − 50,000 = ₹9,72,222.

Answer: The debenture is a financial liability. Amortised cost is ₹9,46,502 at the end of Year 1 and ₹9,72,222 at the end of Year 2 (figures rounded to the nearest rupee).

Exam tips

In case scenarios, underline words like 'must redeem', 'at the option of the holder' and 'variable number of shares'. They decide the classification.
Always write the reason with the conclusion, such as 'unavoidable obligation to deliver cash, hence financial liability'. Marks are given for the reasoning.
List the items outside financial instruments, such as tax, advances for goods and statutory dues, when a question asks which items qualify.
For effective interest working, show opening balance, interest at EIR, cash paid and closing balance in a small table-like layout of lines.

Practice questions from Financial Instruments: Scope and Definitions

Financial Instruments: Definitions under Ind AS 32 and 109 in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial Instruments: Definitions under Ind AS 32 and 109: frequently asked questions

What is the definition of a financial instrument under Ind AS 32?

It is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. A contract is essential, so statutory items like tax payable are excluded.

What is the difference between a financial liability and an equity instrument?

A financial liability involves a contractual obligation to deliver cash or another financial asset, or to exchange on unfavourable terms. An equity instrument shows a residual interest in net assets with no such unavoidable obligation.

Is a redeemable preference share equity or a liability?

If redemption is mandatory or at the holder's option, it is a financial liability under Ind AS 32. A preference share with no redemption obligation and discretionary dividends is equity.

What is amortised cost under Ind AS 109?

It is the initial amount adjusted for principal repayments and the cumulative amortisation of any difference using the effective interest method, and for assets, adjusted for any loss allowance. Interest is computed on the opening amortised cost at the effective interest rate.