Contractual obligation to deliver cash or other financial assets
Impact on the classification
A critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation of the issuer either to deliver cash or another financial asset to the holder or to exchange financial assets or financial liabilities with the holder under conditions that are potentially unfavourable to the issuer (IAS 32.17).
Dividends and shareholder discretion
It is true that holders of typical equity instruments receive dividends, but the issuer is (usually) not contractually obliged to pay dividends on e.g. share, therefore they are not classified as a liability (IAS 32.17).
It may not always be obvious whether shareholders are the same as the ‘entity’. In most jurisdictions, dividends are decided by shareholders at a general meeting and it is widely accepted that shareholders acting as one body are considered to be the entity, i.e. their right to declare dividends does not affect the equity vs. liability distinction. But there may be rare cases where holders of one particular class of equity may declare dividends to themselves without consent of entity’s general meeting, in such cases such financial instruments will more likely be classified as liabilities.
Substance vs. legal form
IAS 32 clarifies that the substance of a financial instrument, rather than its legal form, governs the classification. Paragraph IAS 32.18 provides examples of financial instruments that take the legal form of equity but are liabilities in substance and of those that combine features associated with equity instruments and features associated with financial liabilities.
Implicit obligations and economic compulsion
Financial instruments that have an implied contractual obligation to deliver cash are also treated as financial liabilities (IAS 32.20). Examples given by IAS 32 include:
- a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or to redeem the instrument,
- an instrument that gives the entity a choice between delivering cash or its own shares whose value is determined to exceed substantially the value of the cash.
The above implicit obligations are not to be confused with an economic compulsion that is not contractual. IFRIC March 2006 update confirms that economic compulsion, by itself, does not result in a financial instrument being classified as a liability. Example discussed by IFRIC concerned an irredeemable, callable financial instrument with dividends payable only if dividends are paid on the ordinary shares of the issuer (which themselves are payable at the discretion of the issuer). This instrument included a ‘step-up’ dividend clause that would increase the dividend at a predetermined date in the future unless the instrument had previously been called by the issuer, and it ranked in liquidation before an instrument classified as a liability. The IFRIC agreed that this instrument included no contractual obligation ever to pay the dividends or to call the instrument and that therefore it should be classified as equity under IAS 32.
Contingent settlement provisions
Impact of contingent settlement provisions
If the delivery of cash (or other liability-like settlement of a financial instrument) is contingent on the occurrence or non-occurrence of uncertain future events that are beyond the control of both the issuer and the holder of the instrument, such an 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 control of the issuer.
An exception to the rule above applies if (IAS 32.25):
- the part of the contingent settlement provision that could require settlement in cash or another financial asset is not genuine;
- the issuer can be required to settle the obligation in cash or another financial asset only in the event of liquidation of the issuer; or
- the instrument is covered by the puttable instruments exception.
Contingencies are not genuine
IAS 32 explains that if a contract requires settlement in cash or in a variable number of the entity’s own shares only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur, it is classified as an equity instrument (IAS 32.AG28). Paragraph IAS 32.BC17 further clarifies that this threshold is even less likely than a remote probability. It’s important to remember that the core term is ‘not genuine’ here, it can refer to e.g. contractual provisions inserted into a financial instrument for legal and/or tax reasons only.
Conversely, if a settlement in a fixed number of an entity’s own shares is contractually precluded in circumstances that are outside the control of the entity, but these circumstances have no genuine possibility of occurring, such an instrument is still classified as an equity instrument (IAS 32.AG28).
Preference shares are common in the financial world. However, they are not always called ‘shares’, possibly due to legal and/or tax reasons (payments on debt are usually tax deductible whereas payments on equity aren’t). In assessing whether a preference share is a liability of equity instrument, the general definitions should be applied. For example, when a holder of preference shares has an option to redeem them or they must be redeemed, they are (or contain) financial liabilities (IAS 32.18(a)). Conversely, if only an issuer has such an option, there is no contractual obligation to do so and preference shares are classified as equity. The classification of a preference share as an equity instrument or a financial liability is not affected by non-contractual aspects such as the availability of funds, past practice, intention, economic incentives etc. (IAS 32. AG25-AG26).
It is possible that preference shares or similar instruments are compound instruments and should be split between equity and liability components. This will be the case when e.g. such preference shares are non-redeemable, but come with mandatory fixed dividends that are below market rate.
On our forum we also discussed irredeemable cumulative preference shares. The conclusion was that cumulative preference shares, where the contractual obligation to pay dividends arises on liquidation only, and that liquidation does not meet the conditions specified in IAS 32.16C, are classified as equity. Dividends are recognised only when declared, however unrecognised dividends are disclosed (IAS 1.137) and taken into account in EPS calculation (IAS 33.14).
‘Perpetual’ debt instruments are classified as financial liabilities if the issuer has contractual obligation for interest payments, even if the principal need not be redeemed (IAS 32.AG6).
When a derivative financial instrument gives one party a choice over how it is settled (e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash), it is a financial asset or a financial liability unless all of the settlement alternatives would result in it being an equity instrument (IAS 32.26-27).
IAS 32 contains specific exception concerning puttable instruments that essentially is applicable to the financial statements of open-ended mutual funds, unit trusts, partnerships and similar entities. A puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the instrument holder (IAS 32.11). If there were no specific provisions, puttable instruments would be classified as liabilities as the issuer has contractual obligation to deliver cash. This would result in many counter-intuitive accounting implications as discussed in paragraph IAS 32.BC50.
IAS 32 requires puttable financial instruments that represent a residual interest in the net assets of the entity to be classified as equity provided that specified conditions are met. These conditions are set out in paragraphs IAS 32.16A-16B with additional clarifications in paragraphs IAS 32.AG29A; AG140A-J.
Entities with puttable instruments that don’t fall into the exception described above may end up with no equity at all. IAS 32 clarifies that they are allowed to label the liabilities as e.g. ‘net asset value attributable to unitholders’ and P&L item as ‘change in net asset value attributable to unitholders’. This is illustrated in Illustrative Examples 7 and 8 accompanying IAS 32.
Puttable instruments cannot be treated as equity instruments and they don’t pass the SPPI test, therefore holders of those instruments should classify them into the FVTPL category (IFRS 9.BC5.21, IFRIC May 2017 update).
Additionally, paragraphs IAS 32.16E-16F set out accounting for reclassification of puttable instruments between equity and financial liabilities.
Paragraph IAS 1.136A sets out disclosure requirements for puttable financial instruments classified as equity.
Instruments entitling to a pro rata share of the net assets of the entity only on liquidation
As an exception to the definition of a financial liability, 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 if it meets the criteria specified in paragraphs IAS 32.16C-16D with additional clarifications in paragraphs IAS 32.AG29A; AG140A-J. Additionally, paragraphs IAS 32.16E-16F set out accounting for reclassification of such instruments between equity and financial liabilities.
Contracts settled in the entity’s own equity instruments
An instrument is classified as an equity instrument when an entity has an obligation to deliver fixed number of its own equity instruments for fixed consideration (so called ‘fixed-for-fixed’ criterion). Therefore, some financial instruments settled in equity instruments will be classified as financial liabilities.
Apart from the discussion below, see also the different points on contractual obligation to deliver cash or other financial assets which is also relevant to contracts that can be settled in equity instruments.
Contracts classified as equity
A contract that will be settled by the entity (receiving or) delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. Any consideration received or paid with respect to such contracts is credited or debited directly to equity. Changes in the fair value of an equity instrument are not recognised in the financial statements (IAS 32.22)
It is important to note here that share-based payment transactions within the scope of IFRS 2 are excluded from requirements of IAS 32. Transactions falling in the scope of IFRS 2 are more likely to result in recognition of an equity instrument than those covered by IAS 32, which is a conceptual inconsistency acknowledged by the IASB (IFRS 2.BC110).
Warrants or written call options that allow the holder to subscribe for or purchase a fixed number of non-puttable ordinary shares in the issuing entity in exchange for a fixed amount of cash or another financial asset are also classified as equity instruments (IAS 32.AG13). As a side note: proceeds from unexercised warrants are usually reclassified to retained earnings, but this is not covered in IFRS (see this discussion).
Contracts classified as liabilities
As noted earlier, a contract is not an equity instrument merely because it can be settled in the entity’s own equity instruments. Therefore, when the ‘fixed-for-fixed‘ criterion is not met, a contract is classified as a financial liability. For example, a contract to deliver as many of the entity’s own equity instruments as are equal in value to $1 million is a financial liability. It is important to note that the fixed amount must be expressed in the functional currency of the entity, not with reference to other currency or e.g. price of gold (IAS 32.21). As an exception to this rule, rights, options or warrants to acquire a fixed number of the entity’s own equity instruments for a fixed amount of any currency (i.e. not only functional currency) are equity instruments if the entity offers the rights, options or warrants pro rata to all of its existing owners of the same class of its own non-derivative equity instruments (IAS 32.11).
See also section on implicit obligations and economic compulsion above.
Consolidated vs. separate financial statements
IAS 32 emphasises that the general criteria for consolidation apply also to liability vs. equity distinction. It is possible that a financial instrument is classified as equity in separate financial statements of a subsidiary, but as a liability in consolidated financial statements, e.g. due to terms and conditions agreed directly between the parent and third party holders of the instrument (IAS 32.AG29).
An opposite situation is also possible, i.e. a financial instrument is classified as equity in consolidated financial statements, but as a liability in separate financial statements of the issuing subsidiary. This will happen when e.g. payments on such an instrument depend on actions taken by the parent which are outside of control of the subsidiary.
Compound financial instruments
Definition of a compound financial instrument
There are non-derivative financial instruments that contain both equity and liability components, these are called compound financial instruments and each component should be classified separately by the issuer (IAS 32.28). The holder accounts for such instruments under IFRS 9 (IAS 32.AG30).
Convertible bonds are the most common compound financial instruments and IAS 32 uses them as an example to illustrate its requirements (see also this publication by BDO).
On initial recognition of a compound financial instrument, its carrying amount is allocated to equity and liability components. First, an entity measures the fair value of the liability component and the equity component is the difference between the fair value of the whole instrument (which most often equals the proceeds of the bond issue) 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 equity of the issuer. This option has value on initial recognition even when it is out of the money (IAS 32.AG31(b)).
The fair value of the liability component is measured at the fair value of a similar liability that does not contain any possibility of conversion to equity, which equals the present value of contractual cash flows discounted at market rate (IAS 32.AG31(a)). No gain or loss can be recognised at the initial recognition of a compound financial instrument (IAS 32.31).
The liability component is subsequently measured under IFRS 9 and equity components are not remeasured after initial recognition (IAS 32.36). IAS 32 does not prescribe the exact equity line item in which the equity component should be presented.
Transaction costs that relate to the issue of a compound financial instrument are allocated to the liability and equity components of the instrument in proportion to the allocation of proceeds (IAS 32.38).
The accounting at initial recognition is shown in Illustrative Example 9 accompanying IAS 32. Illustrative Example 10 covers separation of a compound financial instrument with multiple embedded derivative features. Fair value measurements are covered in IFRS 13.
Conversion of a convertible instrument
On conversion of a convertible instrument, the entity derecognises the liability component and recognises it as equity. The original equity component remains as equity. There is no gain or loss on conversion. This accounting treatment is set out in paragraph IAS 32.AG32, which refers only to conversion at maturity. However, IAS 32 is silent on what needs to be done when the conversion takes place before maturity. It is a generally accepted practice that the accounting treatment is the same, i.e. the carrying amount of liability (with interest accrued up to the conversion date) is transferred to equity at the conversion date.
Early redemption or repurchase of a convertible instrument
When an entity extinguishes a convertible instrument before maturity through an early redemption or repurchase in which the original conversion privileges are 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 date of the transaction. Allocation is made the same way as at initial recognition, i.e. the fair value of liability component is determined and the difference between the fair value and carrying amount, after taking into account transaction costs, is recognised in P/L. 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 amended, 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.
Repurchase of a convertible instrument is illustrated in Examples 11 and 12 accompanying IAS 32.
Debt for equity swaps
Debt for equity swaps or, more officially, extinguishing financial liabilities with equity instruments are covered in IFRIC 19. This interpretation addresses the accounting by an issuer when the terms of a financial liability are renegotiated and result in the entity issuing equity instruments to a creditor of the entity to extinguish all or part of the financial liability. It does not address the accounting by the creditor (IFRIC 19.2). Note also that IFRIC 19 does not deal with debt for equity swaps done in accordance with original terms of the liability (see compound instruments above).
According to IFRIC 19:
- The issue of an entity’s equity instruments to a creditor to extinguish all or part of a financial liability is consideration paid in accordance with paragraph IFRS 220.127.116.11.
- Equity instruments issued to a creditor to extinguish all or part of a financial liability are recognised initially at the fair value.
- The difference between the carrying amount of the financial liability (or part of a financial liability) extinguished, and the equity instruments issued, is recognised in P/L.
- When only part of the financial liability is extinguished, consideration is allocated in accordance with paragraph IFRIC 19.8.
IFRIC 19 does not apply to creditors being shareholders of the entity or being members of the same group. For such arrangements, entities can follow the guidance of IFRIC 19 set out above, or treat the whole transaction as an equity transaction (i.e. debit liability / credit equity).
Interest, dividends, losses and gains
Paragraph IAS 32.35 sets out the main principle under which interest, dividends, losses and gains (e.g. on redemption or refinancing) relating to financial liabilities are recognised in P/L, whereas payments on equity instruments are debited directly to equity. Paragraph IAS 32.AG37 illustrates application of this rule to compound financial instruments.
Incremental transaction costs on issuing equity
Incremental and directly attributable transaction costs incurred in issuing or acquiring own equity instruments are recognised as a deduction from equity (IAS 32.37). An incremental cost, as per glossary to IFRS, is one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.
If an entity reacquires its own equity instruments, they are called treasury shares and should be deducted from equity and no gain on loss can be recognised in P/L as a result of transactions on treasury shares (IAS 32.33).
Derivatives on own equity
IAS 32 includes numerous examples illustrating the application of its requirements to 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)
Financial Instruments with Characteristics of Equity are on the IASB’s agenda which aims to amend IAS 32 in the future in order to provide a refined rationale for why a financial instrument would be classified as either a liability or equity.
More about financial instruments
See other pages relating to financial instruments:
Scope of IAS 32
Financial Instruments: Definitions
Derivatives and Embedded Derivatives: Definitions and Characteristics
Classification of Financial Assets and Financial Liabilities
Measurement of Financial Instruments
Amortised Cost and Effective Interest Rate
Impairment of Financial Assets
Derecognition of Financial Assets
Derecognition of Financial Liabilities
Interest-free loans or loans at below-market interest rate
Offsetting of Financial Instruments
Financial Liabilities vs Equity
IFRS 7 Financial Instruments: Disclosures