Scope of IAS 32
IAS 32 establishes principles for the classification of financial instruments, from the perspective of the issuer into financial assets, financial liabilities and equity instruments, and for offsetting financial assets and financial liabilities. Additionally, it deals with the classification of related interest, dividends, losses and gains (IAS 32.2). IAS 32 does not deal with recognition and measurement of financial assets/liabilities as these are dealt with in IFRS 9. Disclosure requirements are set out in IFRS 7.
All entities and all financial instruments are in the scope of IAS 32 with certain exceptions listed in paragraph IAS 32.4.
This chapter discusses also requirements of IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments.
Definition of a financial instrument
A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity (IAS 32.11).
‘Contract’ and ‘contractual’ are an important part of the definitions relating to financial instruments. They refer to an agreement between two or more parties that has clear economic consequences that the parties have little, if any, discretion to avoid, usually because the agreement is enforceable by law. Contracts, and therefore financial instruments, may take a variety of forms and need not be in writing (IAS 32.13). Consequently, assets or liabilities that are not contractual are not financial instruments. For example, taxes and levies imposed by governments are not financial liabilities because they are not contractual, they are dealt with by IAS 12 and IFRIC 21 (IAS 32.AG12).
When the ability to exercise a contractual arrangement is contingent on the occurrence of a future event, it is still a financial instrument, e.g. a financial guarantee (IAS 32.AG8).
Lease liabilities and receivables under a finance lease are also financial instruments (IAS 32.AG9).
The following are examples of items that are not financial instruments: PP&E, inventories, right-of-use assets, prepaid expenses, deferred revenue, warranty obligations (IAS 32.AG10-AG11), gold (IFRS 9.B.1).
Contracts to buy or sell non-financial items and own use contracts
Contracts to buy or sell non-financial items vs definition of financial instruments and ‘own use’ exemption
Contracts to buy or sell non-financial items (e.g. a contract to buy commodities) do not meet the definition of a financial instrument, as they don’t give rise to a financial asset to neither of the parties (i.e. the party paying cash will receive physical asset which is not a financial asset as discussed above). However:
- when these kind of contracts are eligible to be settled net or by exchanging financial instruments (usually contracts on commodities) or
- for similar contracts entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin
such contracts are accounted for as if they were financial instruments. However, this statement does not apply if such contracts were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (IAS 32.8-10,AG20-AG23). This is often referred to as the ‘own use exemption’. See paragraph IFRS 9.2.6 and IFRS 9.BA.2 for more discussion and IFRS 9 IG A.1 for implementation guidance.
When the delivery or receipt of the physical asset has taken place and the payment is deferred beyond that point, a financial instrument arises which a typical trade payable and trade receivable.
Contracts with variable volume
A common challenge in applying the ‘own use’ exemption discussed above is posed by contracts for variable volume. For example, it may be argued that when a company that buys electrical energy on the market and sells it to end customers has de facto written an option to the customer as the customer decides how many units he wants to buy. In practice the most common approach is that these kind of contracts are accounted for as ‘own use’ contracts (i.e. not recognised and measured at fair value) because they are not capable of being settled net by the customer (the option holder) as he cannot store it or easily realise the purchases for cash.
Fair value option
IFRS 9 contains a ‘fair value option’ for contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments even if it was entered into for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements (IFRS 9.2.5).
Rights and obligations arising from contracts with customers
Rights and obligations arising from contracts with customers are accounted for under IFRS 15, and not considered to be financial instruments (IAS 32.AG21, IFRS 15.108).
Financial instruments include also derivatives such as financial options, futures and forwards, interest rate swaps and currency swaps. See the discussion on derivatives contained in paragraphs IAS 32.AG15-AG19. Derivatives are also discussed in more detail in IFRS 9.
Definition of a financial asset
A financial asset is any asset that is (IAS 32.11):
(a) cash (see IAS 32.AG3 for more discussion);
(b) an equity instrument of another entity;
(c) a contractual right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable to the entity
(d) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to receive a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
The most common examples of financial assets are bank deposits, shares, trade receivables, loans receivables.
Financial liabilities vs. equity
A financial liability is any liability that is (IAS 32.11):
(a) a contractual obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity;
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i) a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.
The most common examples of financial liabilities are trade payables, bank borrowings, issued bonds.
An equity instrument is defined by IAS 32 as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities (IAS 32.11). It is also helpful to look at an equity instrument through a reversed definition of a liability discussed above, i.e. whether an instrument in question meets the definition of a liability. In short summary, an issuer of an equity instrument does not have an unconditional obligation to deliver cash or other financial instrument or if it has, it is a fixed amount for fixed number of equity instruments.
The most common examples of equity instruments are ordinary shares, but obviously it gets much more complicated than that. The accounting for equity instruments by their issuers is outside the scope of IFRS 9 (IFRS 9.2.1(d)) therefore the recognition and measurement is governed by IAS 32. Obviously, equity instruments held and accounted for by investors are governed by IFRS 9.
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 equal the ‘entity’. In most jurisdictions, dividends are decided by shareholders at 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 the 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 and 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 is 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):
(a) the part of the contingent settlement provision that could require settlement in cash or another financial asset is not genuine;
(b) 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
(c) the instrument is covered by the puttable instruments exception (discussed below).
Contingencies are not genuine
IAS 32 explains that if a contract requires settlement in cash or 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 usually not). 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, the 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 should be split between equity and liability components, which is discussed below.
‘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 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.
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).
Contracts classified as liabilities
As noted earlier, a contract is not an equity instrument only 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.
On initial recognition of a compound financial instrument, its carrying amount is allocated to its equity and liability components. First, an entity measures 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 as 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). Other scope exemptions are given in paragraph IFRIC 19.3.
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 188.8.131.52.
- 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.
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, including incremental transaction costs, are debited directly to equity. Paragraph IAS 32.AG37 illustrates application of this rule to compound financial instruments.
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.
Criteria for offsetting of financial instruments
As a general rule, offsetting is not allowed in IFRS (IAS 1.32). However, IAS 32 contains specific provisions relating to financial assets and liabilities and in fact it requires offsetting in certain circumstances. Namely, a financial asset and a financial liability should be offset and the net amount presented in the statement of financial position when an entity (IAS 32.42):
(a) currently has a legally enforceable right to set off the recognised amounts; and
(b) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
The above criteria are discussed in paragraphs IAS 32.43-48;AG38-AG39. Examples of circumstances where offsetting is not appropriate are given in paragraph IAS 32.49.
Conditional rights to set off
One of the points discussed in the above paragraphs states that (IAS 32.AG38B-C) the legal enforceable right to set off must not be contingent on a future event and must be enforceable in all circumstances (normal course of business and in the event of default, insolvency or bankruptcy). Therefore, it cannot be assumed that the right of set-off is automatically available outside of the normal course of business. For material items, it’s best to double check with the bankruptcy or insolvency laws in relevant jurisdiction. Conditional rights to set off (e.g. in the event of bankruptcy) are also insufficient to meet the offsetting criteria.
Master netting agreements usually are also conditional and therefore do not meet the offsetting criteria (IAS 32.50).
Unit of account
IAS 32 does not specify whether the offsetting criteria should be applied to entire financial instruments or to specified cash flows. Both approaches are acceptable as discussed in basis for conclusions paragraphs IAS 32.BC105-BC111.
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