Financial Instrument Classification under Ind AS 32 — Debt vs Equity, Compound Instruments, and Perpetual Securities

The classification of financial instruments as debt or equity under Ind AS 32 is one of the most consequential accounting judgments that Indian companies must make — and one where the stakes are highest for financial institutions, where instruments that appear economically similar to equity may be classified as liabilities for accounting purposes, with direct impact on reported leverage ratios, capital adequacy, and earnings quality. The Mumbai financial services sector — home to India’s largest banks, insurance companies, NBFCs, and capital market intermediaries — uses a wide variety of hybrid and structured instruments whose classification under Ind AS 32 is not always intuitive, and where the misclassification of a single large instrument can materially misrepresent a company’s financial position.

The classification principle under Ind AS 32 is straightforward in concept but complex in application. A financial instrument is classified as a financial liability if it contains a contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities under conditions that are potentially unfavourable. It is classified as equity if it represents a residual interest in the assets of the entity after deducting all of its liabilities — which means, in practice, that equity instruments have no contractual obligation to deliver cash unless the entity itself chooses to do so and has the unconditional right to avoid payment. The challenge arises because modern financial instruments are designed to blur this distinction, often for economic or regulatory reasons that are entirely legitimate.

The Debt vs Equity Classification Decision Under Ind AS 32 and Its Financial Statement Impact

Preference shares are the most common classification challenge in Indian corporate practice. A redeemable preference share — one with a mandatory redemption date and a fixed dividend rate — is economically similar to a bond and is classified as a financial liability under Ind AS 32, even though it is legally a share. The mandatory redemption obligation creates a contractual obligation to deliver cash, which is the defining characteristic of a liability. By contrast, an irredeemable preference share with discretionary dividends — where the issuer has no obligation to pay dividends and no obligation to redeem — is classified as equity. Compulsorily convertible preference shares, as discussed in an earlier post, are classified as equity if the conversion terms are fixed — because no cash delivery obligation ever arises — but as a compound instrument with a liability component if the conversion terms are variable, because the variable conversion feature represents a derivative that must be bifurcated and measured separately.

Perpetual bonds and Additional Tier 1 (AT1) capital instruments issued by Indian banks present a particularly complex classification question. AT1 instruments are designed to absorb losses through write-down or conversion triggers, are perpetual in nature (no maturity), and carry discretionary interest payments that can be cancelled without triggering a default. Under Ind AS 32, these features — particularly the combination of perpetual nature and unconditional right to cancel interest — support an equity classification. However, the Basel III regulatory framework treats AT1 instruments as capital, and the RBI’s Basel III implementation in India includes specific conditions about the write-down trigger and loss absorption mechanism. For Indian banks that have issued AT1 bonds — and several of Mumbai’s major private and public sector banks have outstanding AT1 issuances — the Ind AS 32 classification is equity, which means these instruments are reported as equity on the Ind AS balance sheet but excluded from Common Equity Tier 1 for regulatory capital purposes, creating a permanent divergence between the accounting and regulatory presentations of capital structure.

Puttable instruments — financial instruments that give the holder the right to put the instrument back to the issuer for cash — are generally classified as financial liabilities under Ind AS 32, because the put right creates a potential obligation to deliver cash. However, the standard includes a limited exception for puttable instruments that represent the most subordinated class of instruments in the entity’s capital structure and that exhibit specific characteristics — effectively, they are classified as equity if they meet all of the exception’s conditions. For Indian investment funds structured as limited partnerships or similar vehicles, the interests held by limited partners are often puttable, and the determination of whether those interests are equity or debt under Ind AS 32 has significant implications for how the fund’s leverage and distribution capacity are presented in its financial statements.

The valuation implications of Ind AS 32 classification are direct and material. When a compound instrument is identified — containing both a liability component and an equity component — the liability component is measured first at fair value, and the residual is allocated to the equity component. This means the equity component is defined as the difference between the total instrument’s fair value and the fair value of the liability component. For convertible bonds with variable conversion terms, the derivative liability component is measured using an option pricing model, and its fair value at issuance determines the initial carrying value of both the liability host and the equity residual. For Mumbai-based companies that have issued convertible notes, structurally complex preference shares, or hybrid capital instruments without obtaining a Ind AS 32 classification opinion and a supporting Ind AS 109 fair value assessment, the risk of misclassification and mis-measurement is a genuine financial reporting exposure that auditors are increasingly surfacing.

The practical implications of Ind AS 32 classification for Indian financial institutions extend into their capital adequacy reporting in ways that require careful coordination between the finance and treasury functions. An instrument classified as equity under Ind AS 32 — because it has no contractual obligation to deliver cash — may nonetheless be treated as debt for regulatory capital purposes if it does not meet the specific criteria for inclusion in Tier 1 or Tier 2 regulatory capital under RBI’s Basel III framework. Conversely, an instrument classified as a financial liability under Ind AS 32 may qualify as Additional Tier 1 capital for regulatory purposes if it meets the loss absorption criteria prescribed by RBI. These divergences between accounting classification and regulatory capital treatment are not errors — they reflect the fact that accounting standards and prudential regulations serve different objectives — but they must be explicitly tracked and disclosed so that financial statement users can reconcile the two presentations.

The treatment of written put options on non-controlling interests in consolidated financial statements under Ind AS 32 is an area of particular complexity for Indian holding companies and PE-backed businesses that have provided exit rights to co-investors. When a parent company writes a put option giving a minority shareholder the right to sell their stake to the parent at a predetermined price or formula, the accounting question under Ind AS 32 is whether the put creates a present obligation to purchase the minority interest — in which case the minority interest is derecognised and replaced with a financial liability at the present value of the exercise price — or whether it is simply a derivative to be measured at fair value. Different interpretations of the standard have led to divergent accounting practices in India and internationally, and the IASB has provided guidance that still leaves room for judgment in specific fact patterns.

For Mumbai-based listed companies with complex capital structures — preference shares, warrants, convertible notes, and earn-out arrangements from prior acquisitions — the Ind AS 32 classification exercise is not a one-time exercise at the time of instrument issuance. It must be revisited whenever the terms of an instrument change — through modification, restructuring, or conversion — because the classification must reflect the terms of the instrument as they stand at each balance sheet date. An instrument that was classified as equity at issuance may become a liability if a modification introduces a contractual cash delivery obligation. The registered valuer and the company’s accounting advisor must work in coordination to ensure that the classification review is timely and that the financial statement impact of reclassification is properly measured and disclosed.

Our practice at Harshul Mangal & Associates provides financial instrument classification opinions and valuation support under Ind AS 32 and Ind AS 109, with the analytical rigour that IBBI Registered Valuer practice (Reg. No. IBBI/RV/16/2025/16044) demands — ensuring that compound instrument bifurcation, embedded derivative measurement, and equity/liability classification are consistently documented and audit-defensible.

For further reading on the regulatory framework governing this area, refer to the ICAI guidance on Ind AS 32 — Financial Instruments: Presentation, which provides the primary regulatory foundation for the analysis discussed here.

Our valuation services cover the full range of SFA assignments described in this post — from regulatory compliance to transaction support. If you need professional valuation assistance, we would be pleased to assist. You can reach out to us here or write to harshulmangal.ca@gmail.com.