1. Introduction
In an increasingly sophisticated financial environment, entities often enter into funding arrangements that do not neatly fit into conventional debt or equity classifications. One such instrument is the perpetual loan, typically characterised by the absence of a fixed maturity date and, in certain cases, the absence of mandatory interest payments. At a conceptual level, such instruments may appear to resemble equity, particularly when they are intended to provide long-term financial support. However, their classification under Indian Accounting Standards requires a far more disciplined and principle-based evaluation.
The significance of this classification extends beyond mere presentation. Whether an instrument is treated as a liability or equity has a direct bearing on an entity’s financial ratios, capital structure, borrowing capacity, and stakeholder perception. As such, the issue demands a careful and technically sound analysis.
2. The Core Issue
The central question in the case of perpetual loans is whether such instruments should be recognised as financial liabilities or equity instruments. While the legal documentation may describe them as loans, their economic characteristics, such as the absence of repayment obligations, often lead management to perceive them as equity-like in nature. This tension between legal form and economic substance creates ambiguity, which must be resolved by applying the specific requirements of Ind AS 32, Financial Instruments: Presentation. Let us understand the issue with an example:
2.1 Example
Let’s consider a situation in which an entity receives financial assistance from a promoter or government body in the form of a long-term instrument, such as a perpetual loan. The agreement does not stipulate any repayment timeline, and interest payments, if mentioned at all, are not mandatory. The intention behind such funding may be to provide sustained financial backing rather than to create a recoverable obligation. From a commercial perspective, the entity may view this arrangement as a form of capital contribution. However, accounting standards do not permit classification based solely on management intent or economic perception. Instead, the evaluation must be grounded in the contractual rights and obligations embedded in the instrument.
3. Relevant Provision of the Indian Accounting Standards
Ind AS 32 provides a comprehensive framework for distinguishing between financial liabilities and equity instruments.
A financial liability is defined as any liability that represents 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 to the issuer. Further, even contracts settled in an entity’s own equity instruments may be treated as liabilities if they require delivery of a variable number of equity instruments or fail the “fixed-for-fixed” condition.
In contrast, an equity instrument is defined as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. For an instrument to qualify as equity, it must satisfy two essential conditions. First, it should not contain any contractual obligation to deliver cash or another financial asset. Second, if settlement is to occur in the entity’s own equity instruments, it must involve the exchange of a fixed amount of cash for a fixed number of equity instruments.
A critical principle embedded in Ind AS 32 is that classification must be made at the time of initial recognition, based on the substance of the contractual arrangement rather than its legal form or nomenclature. This principle is particularly relevant in the case of perpetual loans, where the label “loan” may not accurately reflect the underlying economic and contractual realities.
4. Key Considerations for Classification
The classification of a perpetual loan under Ind AS requires a careful assessment of its contractual terms, particularly to determine whether it creates any obligation to deliver cash or another financial asset. In this regard, certain key considerations play a crucial role in deciding whether the instrument should be classified as a financial liability or equity. Let us understand each of these considerations.
4.1 Contractual Obligation to Repay Principal
The first and most decisive factor in classification is the existence of a contractual obligation to deliver cash or another financial asset. Even if a perpetual loan does not specify a repayment date, the presence of any clause that requires repayment, whether immediately, on demand, or upon the occurrence of certain events, indicates the existence of a financial liability.
For instance, if an agreement provides that the amount becomes repayable upon liquidation, regulatory changes, or achievement of specified financial milestones, such clauses create an obligation that cannot be ignored. Conversely, if the agreement clearly establishes that the entity is under no obligation to repay the amount under any circumstances, the instrument begins to exhibit characteristics of equity.
4.2 Obligation to Pay Interest or Returns
Another critical consideration is whether the entity has unconditional discretion over the payment of returns, such as interest or coupons. Where the terms mandate periodic payments, the instrument creates an unavoidable obligation to deliver cash, thereby qualifying as a financial liability. However, if the issuer has complete discretion to decide whether or not to make such payments, and non-payment does not trigger default or additional obligations, this supports equity classification.
For example, an instrument that allows the entity to indefinitely defer or completely avoid interest payments without consequence aligns more closely with the definition of equity, provided no other obligations exist.
4.3 Unconditional Right to Avoid Settlement
The ability to avoid settlement is equally central to the analysis. Ind AS 32 emphasises that an instrument can be classified as equity only if the issuer has an unconditional right to avoid delivering cash or another financial asset.
If the counterparty has the right to demand repayment at any time, or if the entity is otherwise compelled to settle the obligation under certain conditions, the instrument must be classified as a liability. In contrast, if the issuer retains complete control over whether any payment will ever be made, and the counterparty has no enforceable claim, the absence of an unavoidable obligation supports equity classification.
4.4 Fixed-for-Fixed Test
In some cases, settlement may occur through the issuance of the entity’s own equity instruments. Here, the “fixed-for-fixed” condition becomes relevant. If the instrument requires the entity to deliver a variable number of its own equity instruments, it is treated as a financial liability. Only where the settlement involves a fixed amount of cash in exchange for a fixed number of equity instruments can it qualify as equity. Although this aspect may not always arise in the context of perpetual loans, it becomes relevant where conversion or settlement features are embedded in the instrument.
4.5 Embedded and Contingent Obligations
Another important aspect is the presence of implicit or embedded conditions within the agreement. Often, contractual arrangements include clauses that may not be immediately apparent but can create obligations under specific circumstances. These may include performance-linked repayment triggers, regulatory contingencies, or clauses tied to future profitability. Even if such conditions are contingent, their existence introduces an element of obligation that must be considered in the classification analysis.
4.6 Substance of the Arrangement
Finally, while the principle of substance over form is fundamental to financial reporting, it cannot override the explicit requirements of Ind AS 32. An instrument may appear equity-like in substance, particularly when intended to serve as long-term capital support. However, if the contractual terms impose any form of obligation, whether explicit or implicit, the instrument must be classified as a financial liability. Thus, substance must be evaluated within the boundaries of the standard, rather than used to bypass its requirements.
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