Accounting of Compound Financial Instruments under Ind AS 32 and Ind AS 109 — A Practical Guide

1. Background & Context

Companies today increasingly rely on hybrid funding instruments like CCDs, CCPS and OCDs. These instruments are attractive because they combine the cash-flow features of debt with the strategic flexibility of equity. A CCD may look like debt when it pays interest, but it turns into equity on conversion. A CCPS may resemble equity on day one, but its dividend and redemption terms behave like debt. An OCD may act like a straight loan until the holder exercises a conversion option.

On paper these instruments are presented as a single security; in substance, they often contain multiple economic features, each behaving differently. One feature may create a present obligation to pay cash, another may give a right to receive equity in the future, and a third may expose the issuer to movements in market price. This mix is exactly why Ind AS does not allow them to be classified purely as debt or purely as equity.

Ind AS requires us to recognise the economic reality hiding inside the instrument. If one contract contains both a debt-like obligation and an equity-like conversion right, it must be split into components. If the conversion terms move with market price, a derivative may also exist.The purpose of compound financial instrument accounting is simple: separate each promise, measure each promise, and present each promise honestly.

This article explains how CCDs, CCPS and OCDs are classified and accounted for under Ind AS, using the four CCD scenarios as the foundation. With clear logic and practical examples.

2. Definition of a Compound Financial Instrument

Before examining compound financial instruments, it is important to revisit the foundation on which their classification is built. As per Ind AS 32, a financial instrument is a contract that gives rise to a financial asset for one entity and a financial liability or equity instrument for another.

In other words, a financial instrument exists whenever a contract creates (a) an obligation to deliver cash, (b) a right to receive cash, or (c) a claim on the residual interest of the issuer. This basic definition becomes relevant because hybrid instruments do not contain a single promise—they typically contain several.

A compound financial instrument arises when a single legal contract contains features that fall into different accounting categories under Ind AS. As per the standard, an instrument is considered compound when it contains both a liability component and an equity component from the issuer’s perspective. For example, a CCD that carries a coupon obligation creates a financial liability, while its fixed-for-fixed conversion feature creates an equity component. Although legally it is a single security, economically it behaves like two instruments combined.

In other words, this can be illustrated through a straightforward example. Consider a CCD issued for ₹100, carrying an 8% annual coupon and mandatorily convertible into 10 fixed equity shares at maturity. The coupon represents a present obligation to pay cash and therefore constitutes a financial liability. The fixed conversion ratio represents a commitment to deliver a fixed number of equity instruments and qualifies as an equity component. Although the CCD is issued as a single contract, the economic characteristics clearly belong to two different categories under Ind AS, and accordingly the instrument must be separated into liability and equity at initial recognition.

If the same CCD included a conversion formula linked to future market prices, or contained a floor or cap on the conversion price, the conversion feature would no longer qualify as equity. Its value would fluctuate with equity price movements and must therefore be separated and accounted for as an embedded derivative under Ind AS 109. In such cases, the instrument contains a liability component and a derivative component, with no equity component.

This definition forms the basis of the classification and measurement principles discussed in the next section.

Section 3 — Classification of Compound Financial Instruments

The classification of a compound financial instrument under Ind AS 32 depends entirely on the contractual terms of the instrument—not on its legal name. Whether an instrument is labelled CCD, CCPS or OCD is irrelevant. What matters is the economic substance of the promises contained in the contract.

Ind AS requires the issuer to examine each feature and determine whether it creates:

• a financial liability,
• an equity component, or
• an embedded derivative.

To arrive at the correct classification, three fundamental questions must be answered.

3.1 Core Classification Tests under Ind AS 32

1. Is there a contractual obligation to deliver cash?

If the issuer must pay:

• coupon / interest,
• mandatory dividend,
• redemption amount, or
• any fixed cash settlement,

then the instrument contains a financial liability, regardless of its legal description.

2. Does the conversion meet the “fixed-for-fixed” test?

A conversion feature qualifies as equity only when:

• the number of shares to be issued is fixed, and
• the amount to be settled is fixed (or determinable in equity form only).

If either the number of shares or the settlement value varies, the feature fails to qualify as equity.

What Does “Fixed-for-Fixed” Mean Under Ind AS 32?

For a conversion feature to qualify as equity, Ind AS 32 requires that it meets the fixed-for-fixed test. This principle ensures that the issuer delivers a fixed number of equity shares in exchange for a fixed amount of value.

Two conditions must be met simultaneously:

1. Fixed Number of Shares (Fixed “Number”)

The issuer must be required to issue a predetermined, unchanging number of shares at conversion.

• Example (Equity):
  “100 CCDs convert into 10 shares each.”
• Example (Not Equity):
  “100 CCDs convert into shares worth ₹100.”
  (Number of shares will vary → fails equity test.)

2. Fixed Amount (Fixed “Value”)

The amount being settled through conversion must be fixed at inception, meaning:

• the face value or principal is fixed, and
• the conversion formula does not adjust with market price movements.

This fixed amount is often described as the “fixed amount of cash or fixed liability extinguished.”

If the amount being extinguished is fixed, and the number of shares delivered is fixed, then the conversion feature qualifies as equity.

When Fixed-for-Fixed Fails

Equity classification fails if either fixed condition is violated:

Fails Condition 1 — Variable Number of Shares

If the number of shares changes (e.g., based on market price):

• Conversion at future fair value
• Conversion into “shares worth ₹100”
  Result → Liability, not equity.

Fails Condition 2 — Variable Settlement Amount

If the amount being extinguished is not fixed, e.g.,:

• Amount resets
• Conversion value increases with market conditions
  Result → Liability or Derivative, not equity.

Summary

3. Does any term expose the issuer to equity price variability?

If the conversion formula moves with:

• future fair value per share,
• market-linked adjustments,
• floors or caps,
• anti-dilution clauses, or
• reset mechanisms,

the feature behaves like a derivative, not equity.

3.2 Applying the Tests — Practical Illustrations

The classification rules become clearer through below small simple examples.

Example A — Coupon + Fixed Conversion (Compound Instrument)

• CCD carries 8% coupon
• Converts into 10 fixed shares

Result:

• Coupon → Liability
• Fixed conversion → Equity
• Instrument = Compound Financial Instrument (Liability + Equity)

Example B — Variable Conversion with Fixed Monetary Value (Pure Liability)

• CCD converts into shares worth ₹100 on maturity
• Number of shares varies

Result:

• Issuer settles a fixed cash value, only using shares as a mechanism
• No equity risk
• Entire instrument = Financial Liability

Example C — Variable Conversion Based on Fair Value (Liability)

• Conversion at future market price
• Shares to be issued vary with equity price

Result:

• Fails fixed-for-fixed
• Equity price exposure exists
• Instrument = Financial Liability (no equity component)

Example D — Variable Conversion with Floor/Cap/Reset (Liability + Embedded Derivative)

• Conversion based on market value with floor or cap
• Holder protected against dilution
• Conversion behaves like an option

Result:

• Host → Liability
• Conversion feature → Embedded Derivative (separated and measured at FVTPL)

3.3 Summary

A compound financial instrument may contain:

• only liability, or
• liability + equity, or
• liability + derivative, or
• in rare cases, only equity (e.g., zero-coupon fixed-conversion CCD).

The principle is consistent, and Classification is driven by contractual obligations and conversion mechanics, not by instrument name or management intent.

4. Initial Recognition

At the time of issue, a CCD and other compound financial instrument must be analysed to determine which components it contains and how each component should be measured. Ind AS 32 requires the issuer to identify all liability, equity and derivative elements within the instrument, while Ind AS 109 governs how those components are measured.
The four CCD scenarios below cover the classification outcomes most commonly seen in practice.

4.1 Scenario 1 — CCD Entirely Equity

(No coupon + fixed conversion ratio)

A CCD may qualify as entirely equity when:

• there is no contractual obligation to pay cash (i.e., no coupon/interest),
• redemption is not required, and
• the conversion feature satisfies the fixed-for-fixed criterion (fixed number of shares for a fixed amount).

Why it is equity:

The issuer has no obligation to deliver cash at any stage. The only obligation is to issue a fixed number of equity shares, which meets the definition of an equity instrument under Ind AS 32.

Embedded example:

A CCD issued at ₹100, convertible into 5 fixed shares after 5 years, with no coupon.
The issuer has no liability component; the entire instrument is recognised as equity.

4.2 Scenario 2 — Compound CCD (Liability + Equity)

(Coupon + fixed conversion ratio)

This is the classic compound financial instrument.
The CCD contains two distinct obligations:

Components identified:

• Liability component: the coupon or interest obligation
• Equity component: fixed-for-fixed conversion feature

Measurement at initial recognition:

1. Liability
   • Measured at the present value of future cash flows (coupon + principal, if any),
   • discounted using the market rate for similar non-convertible debt.
2. Equity (residual)
   • Determined as:
     Issue proceeds – Liability component

Embedded example:

CCD issued at ₹100

• Coupon: 8%
• Market rate for similar non-convertible debt: 12%
• Fixed conversion: 10 shares

PV of liability (discounted at 12%) may come to ₹92.
Equity component = ₹100 – ₹92 = ₹8.
Both components are recognised separately.

4.3 Scenario 3 — Pure Liability CCD

(Variable conversion formula designed to deliver a fixed monetary value)

In some CCD structures, the number of shares varies so that the holder ultimately receives a fixed rupee value, not a fixed number of shares.

Key characteristics:

• Issuer is obliged to deliver value, not ownership.
• Shares act merely as a settlement mechanism.
• No equity risk is assumed by the holder.

Classification outcome:

• Entire instrument = financial liability
• No equity component
• No embedded derivative (because the feature is closely related to the debt host)

Embedded example:

CCD of ₹100 converts into shares worth ₹100 at maturity, calculated as:
No. of shares = 100 ÷ Share Price on conversion.
The number of shares varies with price, but the value is fixed → Pure liability.

4.4 Scenario 4 — Liability with Embedded Derivative

(Variable conversion with equity-price linkage, floor/cap, reset)

This scenario arises when the conversion feature exposes the issuer to equity price risk. The conversion formula is not merely a settlement mechanism but behaves like an equity option.

Two sub-scenarios exist:

4.4A Variable conversion based on fair value (no floor/cap)

• Conversion at future market price
• Number of shares varies with share price
• Fails fixed-for-fixed
• But conversion is linear (no option-like payoff)

Classification:

• Entire CCD = Liability
• No separate derivative
• Measured as a single host liability at amortised cost

Example:
Conversion price = market price at maturity.
Outcome = full liability classification.

4.4B Variable conversion with floor/cap/anti-dilution/optionality

This is where an embedded derivative must be separated because the payoff is no longer linear.

Indicators of an embedded derivative:

• Floor price protection
• Cap on conversion
• Reset/redetermination clauses
• Anti-dilution adjustments
• Holder/issuer conversion option

These features create non-closely related equity-linked risk.

Classification:

• Host liability: Present value of contractual debt cash flows
• Embedded derivative: Measured at fair value through profit or loss (FVTPL)
• No equity component

Embedded example:

CCD convertible at market price but not below ₹80 (floor).
If market price falls below ₹80, issuer must issue more shares—creating an option-like benefit for the holder.
Therefore:

• Host debt = Liability
• Floor protection = Embedded derivative (FVTPL)

4.5 Summary of All Four Scenarios

4.6 Measurement of Components: How to Derive Liability, Equity and Embedded Derivative Amounts

Once a CCD is classified into its components, Ind AS 32 and Ind AS 109 require each component to be measured separately at initial recognition. The measurement follows a consistent principle of followings:

• Liability is measured first, using present value;
• Equity is measured as a residual, if applicable;
• Embedded derivatives are measured at fair value, when the conversion feature exhibits option-like characteristics.

This section explains how to determine each component and how to compute the correct effective interest rate (EIR) that will apply to the liability going forward.

A. Measuring the Liability Component (PV Method)

(Applicable when a liability component and equity component coexist)

The liability is measured as the present value of all contractual cash flows, discounted using the market rate for similar non-convertible debt.

Cash flows included:

• Contractual coupons or interest
• Mandatory dividend (if contractual)
• Redemption amount (if any)

Discount rate used:

• Market yield for comparable plain debt with similar terms
• Reflects issuer credit risk and tenor
• Never the coupon rate
• Never the conversion-related rate

Liability Component = Present Value of (Future Coupons + Redemption Amount), discounted at the market rate for similar non-convertible debt

This ensures the liability reflects the economic cost of borrowing without the conversion feature.

B. Measuring the Equity Component (Residual Method)

(Applicable only when the conversion meets the fixed-for-fixed test)

Once the liability is computed at present value, the equity component is simply the residual: Equity Component=Issue Proceeds−Liability Component

The equity component is not remeasured subsequently.
It remains fixed in equity throughout the instrument’s life.

C. Measuring the Embedded Derivative (Fair Value Method)

(Applicable when conversion terms contain floor/cap/reset/option features)

Derivative Fair Value is the present value of the economic benefit embedded in the conversion feature—measured as the amount a market participant would pay or receive today for the option-like terms (such as floors, caps, resets or fair-value conversions) in accordance with Ind AS 109. If the conversion feature creates an option-like payoff—for example, through a floor price, cap, anti-dilution clause or market-linked reset—Ind AS 109 requires separation of an embedded derivative.

Measurement steps:

1. Determine fair value of the embedded derivative at inception (FVTPL).
2. Calculate host liability as the residual: Host Liability=Issue Proceeds−Derivative Fair Value (Where, Derivative Fair Value is determined using an option-pricing model (such as Black–Scholes, Binomial Tree, or Monte Carlo simulation) based on market variables like share price, volatility, time to maturity, risk-free rate, and expected dividends. It reflects the fair value of conversion floors, caps, resets, anti-dilution clauses or market-linked conversion terms.)
3. Measure the host liability at amortised cost using its own EIR.
4. Remeasure the derivative at FVTPL at each reporting date.

This ensures the derivative reflects changes in equity-linked risk while the host liability reflects pure debt economics.

D. How to Select the Discount Rate

1. For Liability + Equity Instruments (compound instruments)

Use the market yield for similar non-convertible debt—reflecting risk, currency, tenor and issuer credit profile.

2. For Pure Liability Instruments

Use the market rate as above.

3. For Liability + Derivative Instruments

No separate market discount rate is selected.
The host liability is a residual, and its EIR is computed mathematically through IRR.

⚠️ Common Mistake: Using Coupon Rate as Discount Rate

Using the coupon rate (e.g., 8%) as the discount rate results in incorrect liability measurement.
Ind AS requires the market yield for comparable non-convertible debt.

E. How to Compute the EIR for the Host Liability (IRR Method)

(Required when a derivative is separated)

When a derivative is separated, the host liability is recognised below face value (discounted).
The EIR must be calculated as the rate “r” that equates the present value of future contractual cash outflows to the initial carrying amount of the host liability.

Instrument Details (Illustrative Example)

• Issue proceeds: ₹100
• FV of embedded derivative: ₹6
• Host liability = ₹94
• Annual coupon: ₹8
• Tenure: 5 years
• Redemption: ₹100

IRR Cash Flow

IRR / EIR Equation

94=8(1+r)+8(1+r)2+8(1+r)3+8(1+r)4+8(1+r)5+100(1+r)594 = \frac{8}{(1+r)} + \frac{8}{(1+r)^2} + \frac{8}{(1+r)^3} + \frac{8}{(1+r)^4} + \frac{8}{(1+r)^5} + \frac{100}{(1+r)^5}94=(1+r)8​+(1+r)28​+(1+r)38​+(1+r)48​+(1+r)58​+(1+r)5100​

The IRR calculated becomes the EIR for all subsequent measurement under Ind AS 109.

Solution

The IRR that satisfies this equation is:

EIR ≈ 13.2%

This rate amortises the liability from ₹94 → ₹100 over 5 years.

Why EIR > Coupon?

Because the liability is recognised at a discount (₹94 vs ₹100 redemption), the unwinding requires a higher effective interest rate.

F. Summary of Measurement Approach

5. Subsequent Measurement of Each Component

Once the individual components of a compound financial instrument have been identified and measured at initial recognition, Ind AS 109 governs how each component is subsequently measured over the life of the instrument. The guiding principle is straightforward: each component must continue to reflect its own economic characteristics, even though the legal instrument remains a single contract.

Subsequent measurement therefore differs for the (a) liability component, (b) equity component and (c) embedded derivative component.

5.1 Liability Component — Measured at Amortised Cost Using EIR

The liability component—whether arising from a compound instrument or a pure liability CCD—is measured at amortised cost using the effective interest rate (EIR) determined at initial recognition.

Key points:

• EIR reflects the true economic yield of the liability.
• Interest expense is recognised using EIR, not the coupon rate.
• Coupon payments reduce the carrying amount.
• The liability accretes to its redemption amount over time.

Illustration (Continuing the earlier example):

• Host liability at inception: ₹94
• EIR: 13.2%
• Coupon: ₹8

Year 1 accounting:

• Interest expense = 94 × 13.2% = ₹12.41
• Coupon paid = ₹8
• Increase in liability = 12.41 – 8 = ₹4.41
• Closing liability = ₹94 + 4.41 = ₹98.41

This process continues until the liability reaches the redemption amount of ₹100 at maturity.

5.2 Equity Component — No Subsequent Remeasurement

When the conversion feature qualifies as equity (fixed-for-fixed), the equity component:

• is recognised at inception,
• is not remeasured, and
• remains in equity until conversion.

Why no remeasurement?

Equity represents a residual ownership interest, not a contractual obligation.
Ind AS does not permit revaluation of equity-classified components because any such changes would not reflect changes in obligation but changes in ownership value, which are not recognised until settlement.

5.3 Embedded Derivative Component — Remeasured at FVTPL

When a derivative is separated (e.g., floor price, cap, reset, anti-dilution or variable fair-value conversion), the embedded derivative must be measured at fair value through profit or loss (FVTPL) at every reporting date.

Key points:

• Fair value changes can be significant due to equity price movements.
• Gains/losses flow directly to the Statement of Profit and Loss.
• The host liability and embedded derivative are accounted for independently.

Illustration:

• Derivative FV at inception: ₹6
• Derivative FV at year-end: ₹9
• Gain to holder (loss to issuer): ₹3
• Accounting entry:
  • Dr Loss on Fair Value Change ₹3
  • Cr Derivative Liability ₹3

This ensures the issuer recognises all equity-linked risk arising from the conversion feature.

5.4 Pure Liability Instruments — Subsequent Measurement Same as Borrowings

When a CCD is classified entirely as a financial liability, without equity or derivative components (e.g., variable conversion delivering fixed monetary value), it is measured similarly to a plain borrowing.

Subsequent measurement involves:

• Recognising interest expense at EIR
• Accreting the liability to settlement value
• Reducing the liability for coupon payments

There is no equity and no derivative to track.

5.5 Consolidated View — How Each Component Behaves Over Time

5.6 Key Takeaways

• EIR dominates liability measurement, not the contractual coupon.
• Equity components remain unchanged throughout the instrument’s life.
• Derivative components introduce P&L volatility, reflecting equity-linked risk.
• The instrument’s legal form never impacts measurement—each component follows its applicable Ind AS requirement.

6. Accounting on Conversion

Conversion is the point at which all outstanding components of a compound financial instrument are settled and replaced by equity. Although the legal instrument appears to simply “convert into shares,” the accounting must follow the requirements of Ind AS 32 and Ind AS 109, ensuring that every component—liability, equity or derivative—is derecognised appropriately. The key principle is that conversion does not give rise to any gain or loss, as the settlement occurs entirely through the issuance of equity instruments.

6.1 General Principles of Accounting on Conversion

Regardless of the scenario (liability + equity, pure liability, or liability + derivative), conversion requires three broad steps:

1. Derecognition of the Liability Component

• The carrying amount of the liability at the conversion date is removed from the books.
• Any accrued interest (EIR-based) up to the conversion date is also included in the liability carrying amount.

2. Derecognition of Embedded Derivative (If Any)

• Fair value of the derivative at the conversion date is derecognised.
• Any change in fair value up to the conversion date has already been recognised through P&L.

3. Recognition of Equity Shares Issued

• Share capital is recognised at face value.
• Securities premium is recognised for the balance.
• The total equity recognised equals the carrying amount of the liability plus (where applicable) the derivative and any existing equity component.

6.2 Scenario-wise Application

The equity component recognised at initial recognition is not reclassified to profit or loss on conversion.

A. Conversion of Compound CCD (Liability + Equity)

(Fixed-for-fixed conversion)

At conversion:

• Liability is derecognised.
• Equity component (recognised initially) is transferred to share capital/premium.
• Shares are issued; no gain or loss is recorded.

Example:
On conversion date:

• Liability carrying amount = ₹100
• Equity component (initial) = ₹8

As per Ind AS 32, the equity component recognised at initial recognition is not reclassified to profit or loss on conversion. It is transferred within equity—usually to an other equity under the appropriate equity reserve—and does not form part of share premium.

Journal Entry:

Dr Liability                                  100
Dr Equity Component (Equity Portion)            8
     Cr Share Capital / Share Premium (based on actual issue price)       100
     Cr Other Equity Reserve                            8

B. Conversion of Pure Liability CCD

(Variable conversion delivering fixed monetary value)

The instrument is a financial liability until the date of conversion.

At conversion:

• Entire liability is derecognised.
• No equity component exists.
• Shares issued reflect the settlement of the liability.

Example:
Liability carrying amount: ₹100

Journal Entry:

Dr Liability                                  100
     Cr Share Capital / Securities Premium                100

C. Conversion of Liability + Embedded Derivative CCD

(Variable conversion with floor/cap or option-like features)

At conversion:

• The host liability is derecognised.
• The embedded derivative is derecognised at its fair value on the date of conversion.
• Total amount is transferred to equity.

Example:
On conversion date:

• Host liability = ₹100
• Embedded derivative FV = ₹9

Journal Entry:

Dr Liability (Host)                           100
Dr Embedded Derivative                          9
     Cr Share Capital / Securities Premium                100
      Cr Other Equity                                       9

No gain or loss arises at conversion because the settlement is entirely in equity instruments.

6.3 Why No Gain or Loss Is Recognised on Conversion

Ind AS 32 treats conversion not as a settlement in cash, but as a non-cash extinguishment of the liability in exchange for the issuer’s own equity instruments. Because the transaction involves an internal movement between liability and equity, no profit or loss can arise. Any changes in derivative fair value or liability amortisation are already reflected before conversion.

6.4 Presentation Requirements

• Post-conversion, the CCD ceases to exist.
• Only equity instruments (share capital and securities premium) remain in the balance sheet.
• No part of the equity component is reversed or remeasured.
• Any unamortised portion of issue costs relating to the liability is adjusted through the liability carrying amount at conversion.

6.5 Summary Table — Accounting on Conversion