Financial Liabilities vs Equity (IAS 32)

Last updated: 16 January 2024

The distinction between an equity instrument and a financial liability can often be complicated for the issuer. This complexity arises because certain instruments, despite being legally classified as equity, display economic attributes associated with a financial liability. Moreover, there are complex instruments that possess both debt and equity characteristics, making their classification a matter of significant judgement.

IAS 32 provides the framework for classifying issued financial instruments. This classification is driven by the contractual terms of the instrument and is primarily influenced by the existence of an obligation to deliver cash or other financial assets to the holders of that financial instrument. Moreover, specific criteria are provided for contracts settled with the entity’s own equity instruments and for compound financial instruments.

Let’s explore this further.

Contractual obligation to deliver cash or other financial assets

A critical feature that differentiates a financial liability from an equity instrument is the existence of a contractual obligation by the issuer to either deliver cash or another financial asset to the holder, or to exchange financial assets or financial liabilities under potentially unfavourable conditions for the issuer (IAS 32.17).

Dividends and shareholder discretion

While it is typical for equity instrument holders to receive dividends, the issuer is usually not contractually obligated to pay dividends on shares. Hence, these are not classified as a liability (IAS 32.17). There may be ambiguity about whether shareholders are the same as the ‘entity’. In most jurisdictions, shareholders decide on dividends at a general meeting and are generally considered to be the entity. This means their right to declare dividends does not impact the equity vs liability distinction. However, in rare circumstances, holders of a specific class of equity may declare dividends to themselves without the consent of the entity’s general meeting. In these cases, such financial instruments are more likely to be classified as liabilities.

The FICE Exposure Draft proposes new guidance on factors to consider in evaluating whether the shareholders’ decision can be treated as that of the entity.

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Substance vs legal form

IAS 32 specifies that the substance of a financial instrument, rather than its legal form, dictates its classification. IAS 32.18 provides examples of financial instruments that, although taking the legal form of equity, are liabilities in substance and those that combine characteristics associated with equity instruments and financial liabilities.

Implicit obligations and economic compulsion

Financial instruments that have an implied contractual obligation to deliver cash are also considered as financial liabilities (IAS 32.20). Examples provided by IAS 32 include:

• a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or redeem the instrument,
• an instrument that gives the entity a choice between delivering cash or its own shares, the value of which is substantially greater than the cash.

The above implicit obligations should not be confused with economic compulsion, which is not contractual. As confirmed by the IFRS Interpretations Committee, economic compulsion, on its own, does not result in a financial instrument being classified as a liability.

Contingent settlement provisions

If the delivery of cash (or another liability-like settlement of a financial instrument) depends on uncertain future events beyond the control of both the issuer and the holder, the instrument is classified as a liability (IAS 32.25). IAS 32 clarifies that conditions based on the issuer’s performance (e.g., revenue, net debt/equity ratio) should also be considered to be beyond the issuer’s control. However, IAS 32.25 outlines exceptions to this rule:

• The contingent settlement provision requiring cash or other financial asset settlement is not genuine,
• The issuer is only required to settle the obligation in cash or another financial asset upon liquidation, or
• The instrument is exempt under the puttable instruments exception.

If a contract requires cash settlement or a variable number of the entity’s own shares only on the occurrence of a highly abnormal event that is extremely rare and very unlikely, it is classified as an equity instrument (IAS 32.AG28). IAS 32.BC17 further clarifies that this threshold is even less likely than a remote probability. It’s essential to remember that the key term here is ‘not genuine’. This may refer to, for example, contractual provisions inserted into a financial instrument solely for legal or tax reasons. Conversely, if a settlement in a fixed number of an entity’s own shares is contractually precluded under circumstances outside the entity’s control, but these circumstances have no genuine possibility of occurring, such an instrument is still classified as an equity instrument (IAS 32.AG28).

The FICE Exposure Draft aims to clarify how to reflect the probability of a contingent event occurring and provide guidance on the meaning of ‘liquidation’ and ‘non-genuine’.

Preference shares

Preference shares are a common instrument in the financial landscape, though they are not always referred to as ‘shares’ due to potential legal and tax implications (interest on debt is typically tax-deductible, unlike payments on equity). To determine whether a preference share is a liability or an equity instrument, the standard definitions should be applied. For instance, if a preference share holder has the option to redeem their shares, or if redemption is mandatory, these shares are considered financial liabilities (IAS 32.18(a)). However, if the option to redeem lies solely with the issuer without a contractual obligation, these shares are classified as equity. The classification is not influenced by non-contractual elements such as availability of funds, past practices, intentions, or economic incentives (IAS 32.AG25-AG26).

Preference shares or similar instruments could be compound instruments, warranting a split between equity and liability components. This situation arises when, for instance, the preference shares are non-redeemable but come with obligatory dividends below the market rate.

On our forums, we discussed irredeemable cumulative preference shares. We concluded that these shares, where the contractual obligation to pay dividends arises only on liquidation (and the liquidation does not meet conditions specified in IAS 32.16C), are classified as equity. Dividends are recognised only when declared, although unrecognised dividends are disclosed (IAS 1.137) and considered in EPS calculation (IAS 33.14).

Perpetual debt

‘Perpetual’ debt instruments are considered financial liabilities if the issuer is contractually obliged to pay interest, even without the need to redeem the principal (IAS 32.AG6).

Settlement options

When a derivative financial instrument gives a party the choice of settlement method (e.g., net cash settlement or exchanging shares for cash), it is treated as a financial asset or liability, unless all settlement alternatives would result in it being an equity instrument (IAS 32.26-27).

Puttable instruments

IAS 32 provides a specific exception for puttable instruments, generally applicable to financial statements of open-ended mutual funds, unit trusts, partnerships, and similar entities. A puttable instrument is one that gives the holder the right to sell the instrument back to the issuer for cash or another financial asset, or it is automatically sold back upon an uncertain future event, or the death or retirement of the holder (IAS 32.11). Without specific provisions, puttable instruments would be classified as liabilities since the issuer has a contractual obligation to deliver cash, leading to potential counter-intuitive accounting implications (discussed in IAS 32.BC50).

IAS 32 stipulates that puttable financial instruments representing a residual interest in an entity’s net assets should be classified as equity, provided certain conditions are met (detailed in IAS 32.16A-16B and clarified in IAS 32.AG29A; AG140A-J).

Entities with puttable instruments that do not meet the exception above might end up with no equity. IAS 32 allows these entities to label the liabilities as ‘net asset value attributable to unitholders’ and the P/L item as ‘change in net asset value attributable to unitholders’ (refer to Illustrative Examples 7 and 8 accompanying IAS 32).

Puttable instruments cannot be treated as equity instruments by holders and they do not pass the SPPI test. Therefore, holders should classify them under the FVTPL category (IFRS 9.BC5.21). Refer also to this agenda decision.

Moreover, IAS 32.16E-16F details the accounting for reclassification of puttable instruments between equity and financial liabilities and IAS 1.136A specifies the disclosure requirements for puttable financial instruments classified as equity.

Instruments granting a pro rata share of entity’s net assets only upon liquidation

Contrary to the financial liability definition, an instrument that includes a contractual obligation for the issuing entity to deliver to another entity a pro rata share of its net assets only on liquidation can be classified as equity, provided it meets the criteria specified in IAS 32.16C-16D with additional clarifications in IAS 32.AG29A; AG140A-J. Additionally, IAS 32.16E-16F provide guidelines for reclassifying such instruments between equity and financial liabilities.

Contracts settled in the entity’s own equity instruments

Fixed-for-fixed criterion

An instrument is classified as an equity instrument when an entity is obliged to deliver a fixed number of its own equity instruments for fixed consideration, a principle known as the ‘fixed-for-fixed’ criterion. Therefore, some financial instruments settled in equity instruments will be classified as financial liabilities (IAS 32.21-22).

The FICE Exposure Draft proposes that specific types of adjustments to the number of equity instruments or the amount of cash to be exchanged (e.g. certain adjustments to the conversion ratio or exercise price) would not violate the ‘fixed-for-fixed’ condition.

Contracts classified as equity

A contract will be classified as an equity instrument if it is settled by the entity delivering (or receiving) a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset. Any consideration given or received in relation to such contracts is debited or credited directly to equity. Changes in the fair value of an equity instrument are not recognised in the financial statements (IAS 32.22).

It is crucial to note that share-based payment transactions within the scope of IFRS 2 are excluded from IAS 32 requirements. Transactions under IFRS 2 are more likely to result in the recognition of an equity instrument than those covered by IAS 32. The IASB has acknowledged this conceptual inconsistency in IFRS 2.BC110.

Additionally, warrants or written call options enabling the holder to subscribe for or purchase a fixed number of the issuing entity’s non-puttable ordinary shares for a fixed amount of cash or another financial asset are classified as equity instruments (IAS 32.AG13). As an aside, proceeds from unexercised warrants are typically reclassified to retained earnings, though this is not detailed in IFRS (refer to this forums topic).

Contracts classified as liabilities

As noted earlier, a contract isn’t deemed an equity instrument simply because it can be settled in the entity’s own equity instruments. Therefore, when the ‘fixed-for-fixed’ criterion isn’t met, the contract is classified as a financial liability. For example, a contract to deliver a variable number of the entity’s own equity instruments equalling $1 million in value is a financial liability. It’s worth noting that the fixed amount must be expressed in the functional currency of the entity, not another currency or a commodity like gold (IAS 32.21).

There is an exception where rights, options, or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency are classified as equity instruments if offered pro rata to all its existing owners of the same class of non-derivative equity instruments (IAS 32.11).

Consolidated vs separate financial statements

IAS 32 clarifies that the general criteria for consolidation also apply to the distinction between liability and equity. A financial instrument might be classified as equity in a subsidiary’s separate financial statements, but as a liability in the consolidated financial statements. This could occur due to terms agreed between the parent company and third-party holders of the instrument (IAS 32.AG29).

Conversely, a financial instrument could be classified as equity in consolidated financial statements but as a liability in the issuing subsidiary’s separate financial statements. This might occur when payments on such an instrument depend on actions taken by the parent company, which are beyond the control of the subsidiary.

Compound financial instruments

Compound financial instruments are non-derivative financial instruments that incorporate both equity and liability elements. According to IAS 32.28, the issuer should classify each component separately. However, this requirement does not apply to holders (IAS 32.AG30).

Convertible bonds, the most common compound financial instruments, are often used in IAS 32 as examples to illustrate its requirements.

Initial recognition

Upon initial recognition of a compound financial instrument, its carrying amount is allocated between the equity and liability components. The entity first measures the fair value of the liability component. The equity component’s value is the difference between the fair value of the whole instrument (typically equating to the issuance proceeds) and the fair value of the liability component (IAS 32.31). The equity component in a convertible bond is an embedded option to convert the liability into the issuer’s equity. Even when it is out of the money, this option has value upon initial recognition (IAS 32.AG31(b)).

The fair value of the liability component is measured at the value of a similar liability that does not contain any conversion feature. This is usually the present value of contractual cash flows discounted at the market rate (IAS 32.AG31(a)). At the initial recognition of a compound financial instrument, no gain or loss can be recognised (IAS 32.31).

The liability component is measured subsequently under IFRS 9, while the equity component is not re-measured after initial recognition (IAS 32.36). IAS 32 does not prescribe the exact equity line item where the equity component should be presented.

Transaction costs related to the issuance of a compound financial instrument are allocated to the liability and equity components of the instrument, proportionate to the allocation of proceeds (IAS 32.38). The accounting at initial recognition is demonstrated in Illustrative Example 9 accompanying IAS 32. Illustrative Example 10 provides the separation of a compound financial instrument with multiple embedded derivative features. Fair value measurements are covered in IFRS 13.

Conversion

Upon conversion of a compound instrument, the entity derecognises the liability component and recognises it as equity. The original equity component remains as equity with no gain or loss on conversion. This accounting treatment is laid out in IAS 32.AG32, referring exclusively to conversion at maturity. IAS 32 does not specify the procedure when conversion occurs before maturity. It is generally accepted that the accounting treatment is identical, i.e., the carrying amount of liability (with interest accrued until the conversion date) is transferred to equity at the conversion date.

Early redemption or repurchase

When a convertible instrument is extinguished before maturity through early redemption or repurchase and the original conversion privileges remain unchanged, the entity allocates the consideration paid and any transaction costs for the repurchase or redemption to the liability and equity components of the instrument at the transaction date. The allocation follows the same process as at initial recognition, i.e., the fair value of liability component is determined, and the difference between the fair value and carrying amount, considering transaction costs, is recognised in profit or loss. The remainder is taken to equity (IAS 32.AG33-AG34).

If the terms of a convertible instrument have been amended to induce the conversion, the difference, at the date the terms are modified, between the fair value of the consideration on conversion of the instrument under the revised terms and the fair value of the consideration the holder would have received under the original terms, is recognised as a loss in P/L.

Repurchasing a convertible instrument is illustrated in Examples 11 and 12 accompanying IAS 32.

Debt-for-equity swaps

Debt-for-equity swaps, officially referred to as extinguishing financial liabilities with equity instruments, fall under the scope of IFRIC 19. This interpretation covers the accounting treatment by the issuer when renegotiating the terms of a financial liability, leading to the issuance of equity instruments to a creditor, thus extinguishing all or part of the financial liability. However, IFRIC 19 does not cover accounting treatment for the creditor (IFRIC 19.2). Additionally, IFRIC 19 doesn’t apply to debt-for-equity swaps carried out in line with the original terms of the liability, which are compound instruments.

According to IFRIC 19:

• When an entity issues its equity instruments to a creditor to extinguish all or part of a financial liability, it’s viewed as consideration paid under IFRS 9.3.3.3.
• The equity instruments issued to a creditor to extinguish all or part of a financial liability are initially recognised at fair value.
• The difference between the carrying amount of the financial liability (or part of it) extinguished, and the equity instruments issued, is recognised in profit or loss.
• When only part of the financial liability is extinguished, the consideration is allocated in accordance with IFRIC 19.8.

IFRIC 19 doesn’t apply to creditors who are shareholders of the entity or members of the same group. For such situations, entities can either follow IFRIC 19’s guidance or treat the entire transaction as an equity transaction (i.e., debit liabilities and credit equity).

Interest, dividends, losses and gains

As per IAS 32.35, interest, dividends, losses, and gains (e.g., on redemption or refinancing) relating to financial liabilities should be recognised in P/L, while payments on equity instruments are directly debited to equity. The application of this rule to compound financial instruments is demonstrated in IAS 32.AG37.

Incremental transaction costs on issuing equity

The incremental and directly attributable transaction costs incurred while issuing or acquiring own equity instruments are recognised as a deduction from equity (IAS 32.37). As per the IFRS glossary, an incremental cost is one that wouldn’t have been incurred if the entity hadn’t acquired, issued, or disposed of the financial instrument. We delved into this definition on our forums.

Treasury shares

If an entity reacquires its own equity instruments, these are referred to as treasury shares. They should be deducted from equity, and no gain or loss can be recognised in P/L as a result of transactions on these treasury shares (IAS 32.33).

Derivatives on own equity

IAS 32 provides several examples demonstrating its requirements for derivatives on own equity instruments. These include:

• Forward to buy shares (Illustrative Example 1 accompanying IAS 32).
• Forward to sell shares (Illustrative Example 2 accompanying IAS 32).
• Purchased call option on shares (Illustrative Example 3 accompanying IAS 32).
• Written call option on shares (Illustrative Example 4 accompanying IAS 32).
• Purchased put option on shares (Illustrative Example 5 accompanying IAS 32).
• Written put option on shares (Illustrative Example 6 accompanying IAS 32).

The FICE Exposure Draft aims to expand the IAS 32 guidance regarding some of these topics.

More about financial instruments

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