IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity – When an entity issues a financial instrument, it must determine its classification either as a liability (debt) or as equity. That determination has an immediate and significant effect on the entity’s reported results and financial position. Liability classification affects an entity’s gearing ratios and typically results in any payments being treated as interest and charged to earnings.

Equity classification avoids these impacts but may be perceived negatively by investors if it is seen as diluting their existing equity interests. Understanding the classification process and its effects is therefore a critical issue for management and must be kept in mind when evaluating alternative financing options.

IAS 32 Financial Instruments: Presentation addresses this classification process. Although IAS 32’s approach is founded upon principles, its outcomes sometimes seem surprising. This is partly because, unlike previous practice in many jurisdictions around the world, IAS 32 does not look to the legal form of instruments. Instead, it focuses on the instruments’ contractual obligations.

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1 The fundamental choice of classification as liability or equity

Whether an instrument is classified as either a financial liability or as equity is, the least to say, important as it has a direct effect on an entity’s reported results and financial position.

Liability classification typically results in any payments on the instrument being treated as interest and charged to earnings. This may in turn affect the entity’s ability to pay dividends on its equity shares (depending upon the requirements of local law). IAS 32 Clearly distinguishing liability and equity

Equity classification avoids the negative impact that liability classification has on reported earnings and gearing ratios. In addition, equity classification may come with many additional powers in certain aspects of the company that has recorded that equity (appointment key management personnel, approve financial statements, discharge management etc.).

2. The basics of the classification process

To determine whether a financial instrument should be classified as debt or equity, IAS 32 uses principles-based definitions of a financial liability and of equity. In contrast to the requirements of generally accepted accounting practice in many jurisdictions around the world, IAS 32 does not classify a financial instrument between equity and financial liability on the basis of its legal form. Instead, it considers the substance of the financial instrument, applying the definitions to the instrument’s contractual rights and obligations.

Classification of financial instruments is often a challenging issue in practice. This in part reflects the many variations in the rights and obligations of instruments that are found in different types of entities and in different parts of the world. Moreover, some instruments have been structured with the intention of achieving particular tax, accounting or regulatory outcomes with the effect that their substance can be difficult to evaluate. IAS 32 Clearly distinguishing liability and equity

2.1 The choices in IAS 32

Under IAS 32, a financial instrument can be classified as a liability, as equity or as a compound instrument (an instrument which exhibits elements of both equity and liability classification, which must be accounted for separately). IAS 32 Clearly distinguishing liability and equity

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”. Determining whether an instrument is classified as equity is therefore dependent on whether it meets the definition of a financial liability. IAS 32 Clearly distinguishing liability and equity

2.1.1 Obligations to deliver cash or another financial asset are financial liabilities

The basic principle of liability classification is that a financial instrument which contains a contractual obligation whereby the issuing entity is or may be required to deliver cash or another financial asset to the instrument holder is a financial liability. This principle is reflected in the definition of a financial liability and is explained in detail in ‘What is a contractual obligation to pay cash or another financial asset?‘. IAS 32 Clearly distinguishing liability and equity

Exceptions: Puttable instruments and obligations arising on liquidation

It could not be that easy, so here we go…… IAS 32 Clearly distinguishing liability and equity

Exceptions to this basic principle were introduced in 2008 by amendments to IAS 32 and IAS 1: Puttable Financial Instruments and Obligations arising on Liquidation. The application of these amendments resulted in equity classification for instruments which would otherwise be classified as financial liabilities in some narrowly defined cases.

Let’s hope it is all solved in a decision tree: IAS 32 Clearly distinguishing liability and equity

Does the contract for the instrument contain an obligation for the issuer to deliver cash or another financial asset?

Yes

No

Does the instrument fall within the scope of the puttable instruments and obligations arising on liquidation?

No

Yes

Does the instrument contain any equity components (discretionary dividends, etc)?

Are the criteria in the puttable instruments and obligations arising on liquidation amendments satisfied?

Yes

No

No

Yes

Compound instrument (split the instrument)

Financial liability

Equity

2.1.2 Instruments settled in an entity’s own equity instruments

Applying the basic principle of liability classification to instruments which may or will be settled in an entity’s own equity instruments is more complicated. Classification of these instruments is governed by the so-called ‘fixed‘ test for non-derivatives, and the ‘fixed for fixed‘ test for derivatives. IAS 32 Clearly distinguishing liability and equity

Under the fixed test, a non-derivative contract will qualify for equity classification only where there is no contractual obligation for the issuer to deliver a variable number of its own equity instruments. Under the fixed for fixed test, a derivative will qualify for equity classification only where it will be settled by the issuer exchanging a fixed amount of cash or another financial asset for a fixed number of its own equity instruments. The application of these rules are discussed in ‘Instruments settled in an entity’s own equity instruments‘ below.

A derivative is by IFRS definition – a financial instrument or other contract within the scope of IFRS 9 with all three of the following characteristics.

  • its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
  • it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. IAS 32 Clearly distinguishing liability and equity
  • it is settled at a future date.  IAS 32 Clearly distinguishing liability and equity

Derivative

Non-derivative

Fixed for fixed test: Can the derivative 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?

Fixed test: is, or may the entity be, obliged to deliver a variable number of its own equity instruments?

Yes

No

Yes

No

Financial liability

Equity

Financial liability

Equity

2.1.3 Compound instruments

Finally, some financial instruments contain both equity and liability components. These are referred to as compound instruments. IAS 32 separates a compound instrument into its equity and liability components on initial recognition, a process sometimes referred to as ‘split accounting’. The accounting for compound instruments is discussed in ‘Compound financial instruments‘ below.

The approach to distinguishing between financial liabilities and equity. Here is a comprehensive overview with links to detailed narratives.

Equity instrument

Financial liability

Compound financial instruments

Classification as liability or equity

The entity must on initial recognition of an instrument classify it as a financial liability or equity.

The classification may not subsequently be changed.

An instrument is a liability if the issuer could be obliged to settle in cash or another financial instrument.

An instrument is a liability if it will or may be settled in a variable number of an entities own equity instruments.

Some instruments may have to be classified as liabilities even if they are issued in the form of shares.

Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities

Some instruments that meet the definition of a liability, but represent the residual interest in the net assets of the entity may be classified as equity, in certain circumstances, such as puttable instruments that give the holder the right to put the instrument back to the issuer for cash or another financial asset, automatically on the occurrence of either (i) an uncertain future event or (ii) death of the instrument holder (common in co-operative structures)

Equity instruments issued to acquire a fixed number of the entities own non-derivative equity instruments (in any currency) are classified as equity instruments, provided they are issued pro-rata to all existing shareholders of the same class of the entities own non-derivative equity.

A financial liability is:

  • A contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity; or

  • A contract that will or may be settled in the entity’s own equity instruments and is 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 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.

For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments.

Compound instruments that have both liability and equity characteristics are split into these components.

The split is made on initial recognition of the instruments and is not subsequently revised.

The equity component of the compound instrument is the residual amount after deducting the fair value of the liability component from the fair value of the instrument as a whole.

No gain/loss arises from initial recognition.

3. Does the contract for the instrument contain an obligation for the issuer to deliver cash or another financial asset?

3.1 Contractual obligation

IAS 32’s classification requirements look to an instrument’s contractual rights and obligations. It is therefore necessary to consider what is meant by a contract. IAS 32 13 explains that:

” ‘contract’ and ‘contractual’ 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 thus financial instruments, may take a variety of forms and need not be in writing.”

Liabilities or assets that are not contractual are not financial liabilities or financial assets. For example, income tax liabilities that arise from statutory requirements imposed by governments are not within the scope of IAS 32 (but are accounted for under IAS 12 Income taxes). Similarly, constructive obligations, as defined in IAS 37 Provisions, Contingent liabilities and Contingent assets, do not arise from contracts and are not financial liabilities.

3.1.1 Examples of contractual obligations to pay cash or another financial asset

A Redeemable shares

The basic principle of IAS 32 has the effect that shares which have a fixed date for redemption, or which give the holder an option to redeem the shares at some point in time, are classified as financial liabilities (except for puttable instruments and obligations arising on liquidation amendments). This is because the entity is not able to avoid the obligation to pay cash upon the redemption of the shares (but for members’ shares in co-operative entities and similar instruments differences arise).

Illustration – Shares redeemable at the holder’s option

Entity A issues 1,000 shares with a par value of Currency Unit (CU) 100 each. The holder of the shares has the option to require the company to redeem the shares at par at any given time.

These shares are classified as liabilities. This is because Entity A does not have the ability to avoid the obligation to redeem the shares for cash should the holder exercise his option to redeem the shares.

If the option to redeem the entity’s shares had instead been at the discretion of the issuer, the shares would have been classified as equity. In that situation, the issuer has a right to pay cash to buy back the shares but no obligation to do so.

B Shares with mandatory dividend payments

Where shares are non-redeemable, classification will depend on the other rights attaching to them. IAS 32 Clearly distinguishing liability and equity

It will often be clear from the terms and conditions attaching to an ordinary share that there is no obligation to pay cash or other financial assets, and that it should therefore be classified as equity.

The classification of preference shares may be less straightforward. IAS 32 AG26 contains specific guidance on non-redeemable preference shares. It clarifies that when preference shares are non- redeemable, the classification depends on a careful analysis of the other rights attaching to them.

For instance, if distributions to holders of the preference shares (whether cumulative or non-cumulative) are at the discretion of the issuer, the shares are equity instruments. If distributions are mandatory the shares will be classified as financial liabilities. IAS 32 Clearly distinguishing liability and equity

Illustration – Mandatory dividend payments of a fixed percentage

An entity issues preference shares with a par value of CU 100 each. The preference shares are non-redeemable but require the entity to make annual dividend payments equal to a rate of 8% on the par amount. There are no equity components such as the possibility of further discretionary dividends.

The preference shares will be classified as financial liabilities, as the entity has a contractual obligation to make a stream of fixed dividend payments in the future. This means that the ‘dividends’ will be treated as interest payments and included as an expense in the Statement of Comprehensive Income.

B-1 Perpetual debt instruments

The non-redeemable preference shares in the above example are one type of ‘perpetual’ debt instrument. Other forms of perpetual debt instrument include some bonds, debentures and capital notes. Perpetual debt instruments normally provide the holder with the contractual right to receive payments of interest at fixed dates extending indefinitely. Holders normally have no right to receive a return of principal (although sometimes, in specified circumstances, they may). IAS 32 Clearly distinguishing liability and equity

A perpetual debt instrument which has mandatory interest payments (but no equity components) is a liability in its entirety. The value of the instrument is wholly derived from the mandatory interest payments. IAS 32 Clearly distinguishing liability and equity

C Financial instruments with payments based on profits of the issuer

Financial instruments that include contractual obligations to make payments linked to the financial performance of the issuer are quite common. An example of such an instrument is a share that pays a specified percentage of profits of the issuer each period. The terms of the instrument usually include a definition of “profit” for this purpose. The instrument might be either redeemable or perpetual. IAS 32 Clearly distinguishing liability and equity

An obligation to pay a specified percentage of the profits of the issuer is a contractual obligation to deliver cash. Such an obligation therefore meets the definition of a financial liability (IAS 32 11(a)(i)). IAS 32 Clearly distinguishing liability and equity

This is the case even if the issuer has not yet earned sufficient profits to pay any interest or dividend (see ‘D Restrictions on ability to satisfy contractual obligation‘ below). IAS 32 also makes clear that the ability of the issuer to influence its profits does not alter this classification (IAS 32 25, IAS 32 AG26(f)).

Illustration – Statutory dividend obligations

IAS 32 AG12 makes it clear that liabilities or assets that are not contractual (such as income taxes arising from statutory requirements) are not financial liabilities or financial assets.

In some countries entities may be required under national legislation to pay a dividend equal to a certain percentage of their profits or a certain proportion of their share capital. This is an example of a situation in which the overall obligations conveyed by an instrument are affected by the relevant governing law of the jurisdiction of the issuer.

Application of IAS 32 in this situation requires the issuer to consider whether the statutory imposition is part of the contractual terms of the instrument, or should alternatively be viewed as a separate, non-contractual obligation that is outside IAS 32’s scope. This is a point of interpretation. A common view is that the statutory imposition should be deemed a contractual term if the issuer and the counter-party entered into the arrangement with the knowledge and expectation that the instrument’s cash flows would be affected by the applicable law.

In some cases, the law may create incentives to pay dividends but does not impose an obligation. For example, an entity may be required under statute to pay a dividend equal to a certain percentage of profits in order to retain a particular tax status. In this case, a contractual obligation does not exist. This reflects the fact that the company is not obliged to pay a dividend even though the tax benefits may be so advantageous as to make it very likely that it will do so in practice.

D Restrictions on ability to satisfy contractual obligation

A restriction on the ability of an entity to satisfy a contractual obligation, such as lack of access to foreign currency or the need to obtain approval for payment from a regulatory authority, does not negate the entity’s contractual obligation or the holder’s contractual right under the instrument.

Illustration – Lack of distributable profits to pay a dividend

A company issues preference shares with a mandatory redemption date and a fixed dividend rate. Under local company law, the dividends can only be paid and the shares redeemed if there are sufficient distributable profits to do so. The company currently has no distributable profits.

The lack of distributable profits has no impact on the classification of the shares, which should be accounted for as liabilities (IAS 32 AG26(d).

Conversely, where payment is at the issuer’s discretion, equity classification should not be affected by an issuer’s expectation of a profit or loss for a period, its intention to make distributions or a past history of making distributions (IAS 32 AG26(a) & (b)).

3.1.2 Members’ shares in co-operative entities and similar instruments

IFRIC 2 Members’ shares in co-operative entities and similar instruments clarifies how the requirements of IAS 32 relating to debt/equity classification should be applied to co-operative entities.

A co-operative entity is typically defined by national law along the lines of a society endeavouring to promote its members’ economic advancement by way of a joint business operation (the principle of self-help). Members’ interests in such entities are often referred to as ‘members’ shares’.

Under the version of IAS 32 prior to the amendments relating to Puttable Financial Instruments and Obligations Arising on Liquidation, all instruments which gave the holder the right to demand redemption were classified as liabilities. IAS 32 Clearly distinguishing liability and equity

Many financial instruments issued by co-operative entities, including members’ shares, have characteristics of equity, including voting rights and rights to participate in dividend distributions. However, some such instruments also give the holder the right to redeem them for cash or another financial asset. The co-operative entity’s governing charter, local law or other applicable regulation may in turn set limits on the extent to which the instruments may be redeemed.

IFRIC 2 was issued to address how the principles of IAS 32 should be applied to such redemption terms in determining whether the financial instruments should be classified as liabilities or equity. IAS 32 Clearly distinguishing liability and equity

– Conditions required for equity classification

IFRIC 2 clarifies that where members’ shares in a co-operative would be classified as equity were it not for the ability of members to request redemption of their shares, it still possible to achieve equity classification of those shares if: IAS 32 Clearly distinguishing liability and equity

  • either of these two conditions is present IAS 32 Clearly distinguishing liability and equity
    1. Members’ shares are equity if the entity has an unconditional right to refuse redemption of the members’ shares.
    2. Members’ shares are equity if redemption is unconditionally prohibited by local law, regulation or the entity’s governing charter, or
  • the members’ shares have all the features and meet the conditions relating to the exceptions for puttable instruments and obligations arising on liquidation discussed in ‘5 Puttable instruments and obligations arising on liquidation‘ below.

With regard to condition 2. above, it should be noted that there may be circumstances in which redemption is unconditional only where certain circumstances exist. For example, redemption might be prohibited only as a result of the co-operative failing to meet liquidity constraints set by regulators. This is not an ‘unconditional prohibition’ and, accordingly, the members’ shares are classified as liabilities.

An unconditional prohibition may also apply to only some of the issued shares. For example, redemption may be prohibited only if it would cause the number of members’ shares or the amount of paid-in capital to fall below a specified level. IAS 32 Clearly distinguishing liability and equity

In this situation, members’ shares that are redeemable without breaching the specified limit are liabilities (assuming the co-operative entity has no other unconditional right to refuse redemption, and that the shares do not meet the puttable instruments criteria discussed in ‘5 Puttable instruments and obligations arising on liquidation‘ below).

Illustration – Redemption prohibited by local law

In Country A, local law prohibits co-operative entities from redeeming members’ shares if, by redeeming them, it would reduce paid-in capital from members’ shares below 80% of the original paid- in-capital from members’ shares. The original paid-in capital is CU 800,000.

This is an example of an unconditional prohibition on redemptions beyond a specified amount, regardless of the entity’s ability to redeem members’ shares. While each member’s share may be redeemable individually, a portion of the total shares outstanding is not redeemable in any circumstances other than upon the liquidation of the entity.

Accordingly CU 640,000 will be classified as equity and CU 160,000 as financial liabilities*.

* It is assumed that the shares do not meet the criteria required for equity classification under either the puttable instruments exception or the obligations arising on liquidation exemptions discussed ‘in 5 Puttable instruments and obligations arising on liquidation‘ below

Illustration – Liquidity requirements under local law

The example is the same as above, except that liquidity requirements imposed in the local jurisdiction prevent the entity from redeeming any members’ shares unless its holdings of cash and short-term investments are greater than a specified amount. The effect of these liquidity requirements at the end of the reporting period is to prevent the co-operative from paying more than CU 100,000 to redeem the members’ shares.

As in the example above, the entity classifies CU 640,000 as equity and CU 160,000 as financial liabilities*. This is because the amount classified as a liability is based on the entity’s unconditional right to refuse redemption and not on conditional restrictions that prevent redemption only if liquidity or other conditions are not met.

* Again it is assumed that the shares do not meet the criteria required for equity classification under either the puttable instruments exception or the obligations arising on liquidation exemptions discussed in ‘5 Puttable instruments and obligations arising on liquidation‘ below

2.1.3 Contractual obligation that is not explicit

A contractual obligation need not be explicit. It may instead be established indirectly through the terms and conditions of the financial instrument. IAS 32 20 provides two examples of this:

“(a) a financial instrument may contain a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or to redeem the instrument. If the entity can avoid a transfer of cash or another financial asset only by settling the non-financial obligation, the financial instrument is a financial liability.”

Illustration – Indirect obligation to pay dividends

A financial instrument might contain a condition that the issuer has to transfer a property to the holder of the instrument if it fails to make dividend payments on the instrument. This creates an indirect obligation to make the dividend payments, and the instrument is therefore classified as a liability.

“(b) a financial instrument is a financial liability if it provides that on settlement the entity will deliver either:

  1. cash or another financial asset; or IAS 32 Clearly distinguishing liability and equity
  2. its own shares whose value is determined to exceed substantially the value of the cash or other financial asset.”

This second example makes it clear that liability classification is not avoided by a share settlement alternative that is uneconomic in comparison to the cash obligation (for the issuer).

Illustration – Own share alternative substantially exceeding cash settlement option

Entity A has in issue two classes of shares: A shares and B shares. The A shares are correctly classified as equity. The B shares have a nominal value of CU 1 each and are redeemable in 5 years time at the option of the issuer.

Under the terms of the redemption agreement, the entity has a choice as to the method of redemption. It may either redeem the shares for their nominal value or it may issue 100 A shares. An A share currently has a value of CU 20 and has never traded at a price below CU 10.

The B shares will be classified as a liability. This is because the value of the own share settlement alternative substantially exceeds that of the cash settlement option, meaning that the entity is implicitly obliged to redeem the option for a cash amount of CU 1 (IAS 32 20(b)).

3.2 Contingent settlement provisions

A financial instrument may require an entity to deliver cash or another financial asset, or settle it in some other way that would require it to be classified as a financial liability, but only in the event of the occurrence or non-occurrence of some uncertain future event. The ‘event’ may be within the control of the issuer or of the holder, or beyond the control of both. These types of contractual arrangements are referred to as ‘contingent settlement provisions’. IAS 32 Clearly distinguishing liability and equity

If the issuer is able to control the outcome of the event that would otherwise trigger a payment obligation, it is able to avoid payment. Accordingly, no liability arises. Conversely, if the holder can control the outcome, the holder is effectively able to demand payment and the instrument is classified as a liability. In many instruments, however, neither party controls the ‘event’ in question.

Examples of such provisions are payments triggered by: IAS 32 Clearly distinguishing liability and equity

  • changes in a stock market or other index; IAS 32 Clearly distinguishing liability and equity
  • changes in specified interest rate indices; IAS 32 Clearly distinguishing liability and equity
  • taxation requirements; or IAS 32 Clearly distinguishing liability and equity
  • the financial results of the issuer (such as future revenues or net income). IAS 32 Clearly distinguishing liability and equity

Where a financial instrument contains such a provision, the issuer of the instrument does not have the unconditional right to avoid delivering cash or another financial asset. Therefore the contingent settlement provision results in a financial liability unless one of the following applies:

  • the part of the contingent settlement provision that indicates liability classification is ‘not genuine’ (see ‘3.3 Settlement terms not genuine‘);
  • the issuer can be required to settle the obligation in cash or another financial asset (or such other way that would cause it to be a financial liability) only in the event of liquidation of the issuer; or IAS 32 Clearly distinguishing liability and equity
  • (in relatively rare circumstances) the instrument has all the features and meets the conditions relating to the exceptions for puttable instruments and obligations arising on liquidation (see ‘5 Puttable instruments and obligations arising on liquidation‘ below).
– Illustration of classification process for contingent settlement provisions

Classification process for an instrument containing an obligation arising only on the occurrence or non-occurrence of uncertain future events

It the contingent event within control of the issuer?

Yes

Equity classification

No

Assess whether the part of the contingent settlement provision that indicates liability classification =

Not genuine

Genuine

Can the issuer be required to settle the obligation in cash or another financial asset only in the event of the liquidation of the issuer?

Yes

No

Does the instrument have all the features and meet all the conditions relating to the exceptions for puttable instruments and obligations arising on liquidation?

Yes

No

IAS 32 Clearly distinguishing liability and equity

Financial liability classification

Illustration – Ordinary shares redeemable in event of stock exchange listing

Entity A issues shares that are redeemable at par in the event of the company listing on a stock exchange.

The possibility of the company listing on a stock exchange is a contingent settlement provision. However, it is not clear-cut whether this ‘event’ is within the company’s control.

Common opinion is that there is a reasonable argument that a company is able to avoid listing on a stock exchange if it so chooses (the converse is perhaps more debatable, as obtaining a listing requires the involvement and approval of third parties such as exchange regulators). Under this view, the event in question is within Entity A’s control (and not the holder’s control). Hence the shares would be classified as equity instruments.

Note that the same analysis would not apply if redemption in the example was instead contingent on the sale of the company (via current shareholders selling their shares). Normally the sale of the company would be within the holders’ control meaning the shares would be classified as financial liabilities. However if redemption was only on the sale of the company’s assets, then this may be an event within the company’s control (and hence the shares would not be classified as financial liabilities).

3.3 Settlement terms not genuine

IAS 32 does not directly address when contingent settlement terms are not considered to be genuine. However IAS 32’s Application Guidance notes that:

“a contract that 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 is an equity instrument. Similarly, settlement in a fixed number of an entity’s own shares may be contractually precluded in circumstances that are outside the control of the entity, but if these circumstances have no genuine possibility of occurring, classification as an equity instrument is appropriate.” (IAS 32 AG28)

It is apparent from this guidance then that ‘not genuine’ implies much more than the possibility of settlement being remote. IAS 32 Clearly distinguishing liability and equity

This is consistent with the Basis for Conclusions section in the Standard, where it is noted that


“The Board concluded that it is not consistent with the definitions of financial liabilities and equity instruments to classify an obligation to deliver cash or another financial asset as a financial liability only when settlement in cash is probable.” (IAS 32 BC17)

Illustration – Changes in a stock market index

A financial instrument which must be repaid in the event of a specified change in the level of a stock market index is an example of an uncertain future event that is beyond the control of both the issuer and the holder of the financial instrument, and which would normally result in classification of the instrument as a financial liability.

It is possible however, that the change required in the level of the stock market could be set at such a high level as to be ‘not genuine’. For example, a five-fold increase in the stock market index in a six month period may be historically unprecedented and therefore sufficiently unlikely to be considered ‘not genuine’.

4 Instruments settled in an entity’s own equity instruments

Equity is defined as “any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities”. Only those instruments which fail the definition of a financial liability can be classified as equity. IAS 32 Clearly distinguishing liability and equity

An instrument that will be settled by an entity issuing its own equity instruments does not contain an obligation for the issuer to deliver cash or another financial asset. In the absence of this expanded definition, such an instrument would be classified as equity. However, as the IASB concluded that such an outcome would not reflect the substance of some of these instruments. IAS 32 therefore includes specific rules to govern their classification. Section C discusses these rules, namely the application of: IAS 32 Clearly distinguishing liability and equity

  • the ‘fixed test’ for non-derivatives that may be settled in an entity’s own equity instruments; and IAS 32 Clearly distinguishing liability and equity
  • the ‘fixed for fixed test’ for derivatives that may be settled in an entity’s own equity instruments. IAS 32 Clearly distinguishing liability and equity

Where equity classification is met, any consideration received is added directly to equity while any consideration paid is deducted directly from equity. Changes in the fair value of an equity instrument are not recognised in the financial statements. IAS 32 Clearly distinguishing liability and equity

Where equity classification is not met, the contract will be accounted for either as a non-derivative financial liability, or as a derivative asset or liability, depending on the nature of the contract.

4.1 Non-derivatives settled in an entity’s own equity instruments

4.2 Derivatives settled in an entity’s own equity instruments

Do the ‘fixed’ test
Do the ‘fixed for fixed’ test

The logic behind this test is that using a variable number of own equity instruments to settle a contract can be similar to using own shares as ‘currency’ to settle what in substance is a financial liability.

Such a contract does not evidence a residual interest in the entity’s net assets. Equity classification is therefore inappropriate.

IAS 32 contains two examples of contracts where the number of own equity instruments to be received or delivered varies so that their fair value equals the amount of the contractual right or obligation:

1) A contract to deliver a variable number of own equity instruments equal in value to a fixed monetary amount on the settlement date is classified as a financial liability.

Illustration – Shares used as currency

Entity A issues an instrument for which it receives CU 100,000. Under the terms of the issue, Entity A will repay the debt in 3 years time by delivering ordinary shares to the value of CU 115,000.

Entity A is using its own shares as currency, and the instrument should therefore be classified as a financial liability.

2) A contract to deliver as many of the entity’s own equity instruments as are equal in value to the value of 100 ounces of a commodity results in liability classification of the instrument.

Illustration – Shares to the value of a commodity

Entity B issues preference shares for CU 1,000. The shares pay no interest and will be settled in three years time by Entity A delivering a number of its own ordinary shares (which are correctly classified as equity) as are equal to the value of 100 ounces of gold. Can the preference shares be classified as equity under the fixed for fixed test?

No. The shares must be classified as financial liabilities as the delivery of ordinary shares to the value of 100 ounces of gold represents an amount that fluctuates in part or in full in response to changes in a variable other than the market price of the entity’s own equity instruments.

Even though both of the contracts in these examples are settled by the entity delivering its own equity instruments, the contracts are not equity themselves. In both cases the entity uses a variable number of its own equity instruments to settle them. They are therefore classified as financial liabilities.

This test is based on similar logic to the ‘fixed’ test.

If the ‘fixed for fixed’ test is met, the derivative is classified as equity and falls outside the scope of IFRS 9. Subsequent changes in fair value are not recognised in the financial statements. Note however that special rules apply to derivative contracts which include a obligation for the issuer to purchase its own equity instruments (a written put option) – see ‘4.4 Obligations to purchase own equity instruments for cash‘.

The ‘fixed for fixed’ test is therefore typically crucial when an entity issues (i) a convertible bond or (ii) share warrants or options.

Illustration – Call share option that meets the definition of equity

An issued share option that gives the counterparty a right to buy a fixed number of a company’s shares for a fixed amount of functional currency is an example of an instrument that meets the fixed for fixed test.

Note however that equity classification applies only if the contract can be settled only by ‘gross physical settlement’ – in other words by actual issuance of shares for cash.

For the company that has issued the option, the contract is an equity instrument as it will settle it by issuing a fixed number of its own equity instruments in return for a fixed amount of cash.

Illustration – Call share option that fails the definition of equity

An entity issues a share option that gives the counterparty a right to buy a number of shares for a fixed price. Under the terms of the option agreement, however, the number of shares that the counterparty obtains by paying the exercise price varies according to the level of sales that the entity achieves.

The option fails the fixed for fixed test as it is over a variable number of the entity’s shares. The definition of equity is not met, and the option will therefore be accounted for as a derivative in accordance with the requirements of IFRS 9 B4.3.2.

It should be noted however that if share options are issued in exchange for goods or services, then IFRS 2 Share-based payment would apply.

The ‘fixed for fixed’ test is not then relevant.

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

4.3 Own equity instruments

For the purpose of applying the fixed for fixed test, ‘own equity instruments’ do not include instruments classified as equity under Puttable Financial Instruments and Obligations arising on Liquidation (see ‘5 Puttable instruments and obligations arising on liquidation‘ below).

Nor do ‘own equity instruments’ include instruments that are contracts for the future receipt or delivery of the issuer’s own equity instruments.

4.4 Obligations to purchase own equity instruments for cash

A contract that contains an obligation for the entity to purchase its own equity instruments for cash or another financial asset gives rise to a financial liability for the present value of the redemption amount (the forward repurchase price, option exercise price or other specified redemption amount) (IAS 32.23). This is the case even for derivatives over equity instruments that meet the fixed for fixed test and would be equity in the absence of the rule in IAS 32.23.

IAS 32.23 also notes that a contractual obligation for an entity to purchase its own equity instruments gives rise to a financial liability for the present value of the redemption amount even if the obligation is conditional on the counterparty exercising a right to redeem.

A contract that contains an obligation for the entity to purchase its own equity instruments for cash or another financial asset gives rise to a financial liability for the present value of the redemption amount (the forward repurchase price, option exercise price or other specified redemption amount) (IAS 32.23). This is the case even for derivatives over equity instruments that meet the fixed for fixed test and would be equity in the absence of the rule in IAS 32.23.

IAS 32.23 also notes that a contractual obligation for an entity to purchase its own equity instruments gives rise to a financial liability for the present value of the redemption amount even if the obligation is conditional on the counterparty exercising a right to redeem. IAS 32 Clearly distinguishing liability and equity

Treatment of options over own equity instruments (settled gross by receipt or delivery of own equity instruments)

Illustration – Written put option

On 1 January 20X1. Company A writes a put option over 1,000 of its own (equity) shares for which it receives a premium of CU 5,000. Company A’s year end is 31 December 20X1.

Under the terms of the option, Company A may be obliged to take delivery of 1,000 of its own shares in one year’s time and to pay the option exercise price of CU 210,000. The option can only be settled through physical delivery of the shares (gross physical settlement).

Although the derivative involves Company A taking delivery of a fixed number of equity shares for a fixed amount of cash, Company A has an obligation to deliver cash which it cannot avoid (note that this is irrespective of the fact that the obligation for Company A to purchase its own equity shares for CU 210,000 is conditional on the holder of the option exercising the option).

On entering into the instrument on 1 January 20X1, the following entries are therefore required to record the premium received and the obligation to deliver CU 210,000 at its present value of CU 200,000 (discounted using an appropriate interest rate).

Cash

CU5,000

Equity – Share premium

CU5,000

To record the premium of the written put option

Equity – Retained earnings

CU200,000

Written put option liability

CU200,000

To record the obligation to deliver own equity instruments

At the year end (31 December 20X1), interest will be recognised in order to unwind the discount that was recorded when the liability was recorded at its present value on its initial recognition.

Interest expenses

CU10,000

Written put option liability

CU10,000

Assuming that the option holder exercises the option, the following entries will be made on 1 January 20X2 to record the derecognition of the liability.

Written put option liability

CU210,000

Cash

CU210,000

If the option holder does not exercise the option by the end of the stated option period, then the liability will be derecognised with a corresponding entry being made to equity.

4.5 Put and call options over non-controlling interests

It is common for a parent entity to hold a controlling interest in a subsidiary in which there are also non-controlling shareholders and to enter into arrangements that:

  • grant the non-controlling interest shareholders an option to sell their shares to the parent entity (a “non-controlling interest written put option”); and/or
  • grant the parent an option to acquire the shares held by the non-controlling interest shareholders (a “non-controlling interest purchased call option”).

Note that such arrangements are sometimes entered into as a result of a business combination and may represent contingent consideration, in which case additional considerations may arise from the application of IFRS 3 Business Combinations.

The accounting for put and call options relating to shares in a subsidiary held by non-controlling interest shareholders is not specifically addressed in IAS 32. The following sections describe some of the application issues that arise as a result. IAS 32 Clearly distinguishing liability and equity

4.5.1 Written put options over non-controlling interests

In the context of consolidated financial statements, non-controlling interests are regarded as own equity instruments unless the terms and conditions which have been agreed between the members of the group and the holders of the instruments mean that the group as a whole has an obligation to deliver cash or another financial asset in respect of the instrument or to settle it in a manner that results in liability classification (IAS 32 AG29). IAS 32 Clearly distinguishing liability and equity

In relation to a written put option entered into by a parent over the shares of a subsidiary IFRIC confirmed that IAS 32 23 applies and such an option is therefore not itself an equity instrument. This is because it contains an obligation to transfer cash on purchase of the non-controlling interests’ shares (this is the case regardless of the fact that the transfer of cash is dependent on the holder of the option exercising it).

Consequently, when a non-controlling interest put option is initially issued, a liability should be recorded for the present value of the redemption amount (which should be estimated if it is not contractually fixed). This liability will subsequently be accounted for in accordance with IFRS 9 at amortised cost, using the effective interest method or subject to the own-use exception at fair value through profit or loss. IAS 32 Clearly distinguishing liability and equity

4.5.2 Purchased call option over non-controlling interests

In contrast to a written put option, a purchased call option entered into by a parent over shares of a subsidiary held by non-controlling interests contains no obligation for the parent entity to transfer cash. Accordingly, such a contract is capable of meeting the definition of an equity instrument.

Equity classification is by no means automatic, however, as it is quite common for the exercise price of the option to be variable (eg the exercise price might be determined using a formula linked to the profitability of the subsidiary). A call option over non-controlling interests will only meet the definition of an equity instrument if its terms are ‘fixed for fixed‘ ie it can only be settled by exchanging a fixed amount of cash for a fixed number of shares. IAS 32 Clearly distinguishing liability and equity

The cost of acquiring a call option over non-controlling interests that meets the definition of an equity instrument is debited to equity, with no further accounting entries being made for changes in the option’s value or on its expiry. Conversely if the call option failed the fixed for fixed test then it would be accounted for as a derivative asset.

Note that options that may or will be net cash-settled are accounted for as normal derivatives, at fair value through profit or loss. IAS 32 Clearly distinguishing liability and equity

4.5.3 Settlement options

Where a derivative financial instrument gives one party a choice between alternative settlement options, for instance where the holder can choose to have the instrument settled net in cash or by exchanging shares for cash, it will be a financial liability unless all of the settlement alternatives would result in it being an equity instrument.

Illustration – Option allowing cash settlement

A share option that the issuer can decide to settle either by exchanging its own shares for cash or by settling net in cash will be classified as a financial liability.

4.6 Problems affecting application of the ‘fixed’ and ‘fixed for fixed’ tests

Whilst the above examples are relatively straightforward, in practice a number of problems emerge when applying these rules.

One of the main problems is determining what exactly is a ‘fixed’ amount of cash or a ‘fixed’ number of equity instruments. Two situations which create particular problems in relation to this are contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency, and changes to the conversion ratio in relation to convertible debt. We discuss these situations below.

4.6.1 Contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency

The question of what exactly is a fixed amount of cash was asked of IFRIC in 2005, in relation to contracts that will be settled by an entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of foreign currency. IAS 32 Clearly distinguishing liability and equity

IFRIC concluded that such contracts, which would for example include a conversion option in a foreign currency denominated convertible bond, are liabilities. They did however decide to recommend that the IASB consider amending IAS 32 so that, for classification purposes only, a fixed amount of foreign currency would be treated as a fixed amount of cash.

A derivative contract which involves an entity delivering a fixed number of its own equity instruments in exchange for a fixed amount of foreign currency fails the ‘fixed for fixed’ test and will be classified as a liability. IAS 32 Clearly distinguishing liability and equity

4.6.2 Changes to the conversion ratio

Another area that frequently raises problems in deciding whether the fixed for fixed test is met or not is changes to the conversion ratio relating to a convertible debt.

Many convertible bonds include conversion options in which the number of ordinary shares received in exchange for each bond (or conversion price) varies in some circumstances. Common types of variation provision include adjustments in the event of: IAS 32 Clearly distinguishing liability and equity

  • a share split, share consolidation, bonus issue or rights issue IAS 32 Clearly distinguishing liability and equity
  • dividend payments in excess of a certain level IAS 32 Clearly distinguishing liability and equity
  • a change of control of the issuer IAS 32 Clearly distinguishing liability and equity

A very narrow or mechanical reading of the fixed for fixed requirement would imply that any such adjustment would result in the conversion option failing the definition of equity. However, the fixed for fixed test should be applied based on the substance of the arrangement. If the conversion ratio varies in certain circumstances, the fixed for fixed requirement may be breached. The factors that cause the conversion ratio to vary should be analysed. IAS 32 Clearly distinguishing liability and equity

Illustration – Adjustments to conversion price that preserve the rights of bondholders

Commonly it is understood that adjustments to the conversion ratio whose effect is simply to preserve the rights of the bondholders relative to the entity’s other equity shareholders do not breach the fixed for fixed requirement.

An adjustment to the conversion ratio will preserve the rights of the bondholders relative to other equity shareholders if its effect is to ensure that all classes of equity interest are treated equally. Such types of adjustment are often referred to as ‘anti-dilutive’ and do not underwrite the value of the conversion option.

Rather they preserve the value of the option relative to the other ordinary shares in specified circumstances. Caution must always be exercised, however, as a clause headed ‘anti-dilutive’ in a legal document may in reality go further than pure anti-dilution and so could cause the fixed for fixed test to be failed.

Other adjustments, for example those that link the number or value of the shares to be received on exercise to the entity’s share price or some other price or index, will breach the fixed for fixed requirement. These conversion options are not equity components although they do represent embedded derivatives within the scope of IFRS 9.

The embedded conversion option must be accounted for as a derivative at fair value through profit or loss although problems of separating the embedded derivative can be avoided by designating the entire instrument at fair value through profit or loss.

In practice, the terms of convertible bonds will need to be analysed carefully to determine the substance of the conversion feature. Judgement will be required to decide whether a conversion option is fixed in economic terms. IAS 32 Clearly distinguishing liability and equity

5 Puttable instruments and obligations arising on liquidation

5.1 Puttable instruments

5.2 Obligations arising on liquidation

“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 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

Since 2008 IAS 32 /IAS 1 include rules-based exceptions to the general principles behind liability or equity classification.

Their effect is that if (and only if) certain strict conditions are met, puttable instruments are classified as equity.

The conditions to be met to achieve equity classification are discussed here with links to detailed narrative for each consideration.

Illustration – Partnership shares

Partnership A is an incorporated partnership that provides legal services. Under the terms of the partnership agreement, new partners are required to pay capital into the partnership. When a partner leaves or retires from the partnership, the capital that he or she initially paid in is repayable at fair value.

The partners’ capital meets the definition of a puttable instrument. This means that it will be presented as equity if all of the conditions are met.

The conditions to be met to achieve equity classification
  1. the instrument entitles the holder to a pro rata share of the entity’s net assets on liquidation;
  2. the instrument is part of a class of instruments that is subordinate to all other classes of instruments;
  3. all financial instruments in this most subordinate class have identical features;
  4. apart from the put feature, the instrument must not include any other contractual obligation to deliver cash or another financial asset to another entity;
  5. the total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity over the life of the instrument;
  6. the issuer must have no other financial instrument or contract that has
    1. total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity (excluding any effects of such instrument or contract) and
    2. the effect of substantially restricting or fixing the residual return to the puttable instrument holders.

The full text of each of the conditions is in the above links, together with a discussion of the application issues that arise from them.

The second exception to the general principles of liability/equity classification relates to certain types of obligation arising on liquidation.

Instruments with these liquidation obligations are classified as equity if a number of conditions are met. The conditions to be met to achieve equity classification are discussed here with links to detailed narrative for each consideration.

These are the conditions
  1. the instrument entitles the holder to a pro rata share of the entity’s net assets on liquidation;
  2. the instrument is part of a class of instruments that is subordinate to all other classes of instruments;
  3. all financial instruments in this most subordinate class have identical features;
  4. the issuer must have no other financial instrument or contract that has
    1. total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity (excluding any effects of such instrument or contract) and
    2. the effect of substantially restricting or fixing the residual return to the puttable instrument holders.

But read on…… IAS 32 Clearly distinguishing liability and equity

There are many similarities between the above conditions and those that need to be met to achieve equity classification of a puttable instrument.

A brief comparison of the conditions above with those set out in in the column on the right in summary or in more detail in ‘5.1 Puttable instruments‘ below shows that conditions 1, 2, 3 and 6 relating to puttable instruments are essentially the same as the four conditions which need to be met for equity classification of an obligation arising on liquidation.

Many of the issues discussed in ‘5.1 Puttable instruments‘ are then equally applicable to instruments containing an obligation arising on liquidation.

There are however some important differences. These are summarised as follows:

  1. there is no requirement that there is ‘no other contractual obligation’ (in addition to the obligation arising on liquidation);
  2. there is no requirement to consider the expected total cash flows throughout the life of the instrument;
  3. the only feature that must be identical among the instruments in the class is the obligation for the issuing entity to deliver to the holder a pro rata share of its net assets on liquidation.

These difference are discuss in more depth in the above links.

5.1.1 The Instrument entitles the holder to a pro rata share of the entity’s net assets on liquidation

The first of the criteria that must be met for a puttable instrument to be classified as equity in accordance with the Amendments is:

“(a) It entitles the holder to a pro rata share of the entity’s net assets in the event of the entity’s liquidation. The entity’s net assets are those assets that remain after deducting all other claims on its assets. A pro rata share is determined by:

  1. dividing the entity’s net assets on liquidation into units of equal amount; and
  2. multiplying that amount by the number of the units held by the financial instrument holder.” (IAS 32 16A(a))

The rationale which underpins this condition is that an entitlement to a pro rata share of the entity’s residual assets on liquidation is consistent with having a residual interest in the assets of an entity.

If the holder of an instrument is not entitled to a pro rata share of the residual assets (ie those assets that remain after all claims have been deducted) on liquidation then the condition is not met and it will not be possible to classify the instrument as equity.

Illustration – Instrument entitled to limited payment on liquidation

Entity Z has two classes of puttable shares – Class A shares and Class B shares. On liquidation, Class B shareholders are entitled to a pro rata share of the entity’s residual assets up to a maximum of CU 100,000. There is no limit to the rights of the Class A shareholders to share in the residual assets on liquidation.

The cap of CU 100,000 means that the B shares do not have entitlement to a pro rata share of the residual assets of the entity on liquidation. They cannot therefore be classified as equity.

The holder’s entitlement to a pro rata share of the residual assets must also be based on the assets of the entity as a whole and not on that of a sub-part of the entity for the condition to be met.

Illustration – Shares in an investment fund

Investment fund Y is comprised of two sub-funds, a South American fund and a Far Eastern fund, and has two classes of puttable share – A shares and B shares.

On liquidation, the A shares are entitled to a pro rata share of the residual assets in the South American fund while the B shares are entitled to a pro rata share of the residual assets in the Far Eastern fund.

The two sub-funds are not considered to be entities in their own right.

Neither the A shares nor the B shares meet the condition in IAS 32 16A(a) as they are entitled to a pro rata share in the residual assets of different sub-funds rather than the entity as a whole.

5.1.2 The Instrument is part of a class of instruments that is subordinate to all other classes of instruments

The second condition that must be met for a puttable instrument to be classified as equity is:

“(b) The instrument is in the class of instruments that is subordinate to all other classes of instruments. To be in such a class the instrument:

  1. has no priority over other claims to the assets of the entity on liquidation, and IAS 32 Clearly distinguishing liability and equity
  2. does not need to be converted into another instrument before it is in the class of instruments that is subordinate to all other classes of instruments.” (IAS 32 16A(b))

Illustration – Priority over other claims on liquidation

An investment fund has two classes of shares in issue:

  • A shares that are puttable instruments
  • B shares which meet the normal criteria for equity classification.

On liquidation, the A shareholders have a preferential right to the first CU 100,000 of residual assets and the B shareholders have a right to the remaining residual assets.

The A shares cannot be classified as equity as they have priority over other claims to the assets of the entity on liquidation.

No materiality threshold applies to the test of subordination, meaning that the most subordinated class of share may on occasion be a very small one. It should be noted that the test of subordination refers to the order of repayment on liquidation only and not at other times. IAS 32 Clearly distinguishing liability and equity

Illustration – Two classes of equity, one class puttable

An entity has issued two types of financial instrument. Instrument A is an instrument without a put right while instrument B is a puttable instrument.

Instrument A meets the normal criteria for equity classification in IAS 32. Does Instrument B’s put feature mean that it has priority over other claims to the assets of the entity and cannot be classified as equity under the puttable instruments exception?

No. IAS 32 16A(b) specifies that the level of an instrument’s subordination is determined by its priority in liquidation. Accordingly, the existence of the put feature does not of itself imply that Instrument B is less subordinate than Instrument A.

5.1.3 All financial instruments in this most subordinate class have identical features

The third condition to be met for a puttable instrument to be classified as equity in accordance with the Amendments is as follows:

“All financial instruments in the class of instruments that is subordinate to all other classes of instruments have identical features. For example, they must all be puttable, and the formula or other method used to calculate the repurchase or redemption price is the same for all instruments in that class.” (IAS 32 16A(c))

To apply this condition, an entity must first of all determine what is the most subordinate class of instruments. For this purpose the most subordinate class of instruments may consist of what are considered to be two or more separate types of instrument for company secretarial purposes.

Illustration – Most subordinate class of shares

Entity E has, in legal terms, two distinct types of puttable shares – A shares and B shares. Both A shares and B shares are subordinate to all other claims on the entity and rank equally on liquidation.

The A shares and B shares together form the most subordinate class of shares.

Having identified, the most subordinate class of instruments, the entity then needs to determine whether all of the items within this class have identical features in order to meet the condition in IAS 32 16A(c). IAS 32 Clearly distinguishing liability and equity

The meaning of the term ‘identical features’ is not elaborated on. Questions arise in practice where there are multiple instruments in the most subordinate class that have relatively minor or non-substantive differences. It is not clear whether ‘identical features’ should be taken literally so as to require every contractual term to be identical, or whether non-substantive differences should be ignored. Under this latter view, further questions arise as to which differences are non-substantive. In the absence of guidance, judgement will need to be applied.

Commonly, it is clear that the features to be evaluated are not limited to financial features such as the redemption price. Non-financial features such as voting rights must also be considered. It is also safe to say that any significant differences in the features of puttable instruments in the most subordinate class will result in all those instruments being classified as financial liabilities.

Illustration – Differences in repayment terms (varying administration fees)

Company E has issued puttable shares which investors may put back to the company.

When an investor puts shares back to the company an administration fee is charged by the company. For shares issued to wholesale investors, the fee is specified as 1%. For shares issued to retail investors the fee is 5%. Can the shares be reclassified as equity?

No. The wording in the standard requires identical terms and different holders are being charged different fees that would result in differing distributions. This fails the identical features condition.

It should be noted that where there are instruments in the most subordinate class of instruments with features that are deemed to be non-identical, it is not possible for the entity to say that one of the types of instrument is more subordinate than the other in order to treat that class of share as equity. A class of instrument is more subordinate than another class only where this accurately reflects the rights of the respective instruments on liquidation. IAS 32 Clearly distinguishing liability and equity

Illustration – Different voting rights

Entity W has two classes of puttable share – A shares and B shares. The A shares and B shares are considered to be equally subordinate to all other classes of instrument on liquidation. The terms of the put options for the A and B shares are the same, and the A and B shares are equally entitled to dividends. The A shares give holders the right to vote in general meetings of the entity, however, while the B shares do not.

Neither of the two classes of puttable share can be classified as equity, as they do not have identical features due to the difference in voting rights. It is not possible for Entity W to achieve equity classification of the A shares by designating them as being more subordinate than the B shares, as this does not reflect the fact that the two classes of share are equally entitled to share in the residual assets of the Entity on liquidation.

5.1.4 No other contractual obligations to deliver cash or another financial asset

The fourth condition to be met for a puttable instrument to be classified as equity is as follows: IAS 32 Clearly distinguishing liability and equity

“Apart from the contractual obligation for the issuer to repurchase or redeem the instrument for cash or another financial asset, the instrument does not include any contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity, and it is not a contract that will or may be settled in the entity’s own equity instruments as set out in subparagraph (b) of the definition of a financial liability.” (IAS 32.16A(d))

The requirement that a puttable instrument contains no other contractual obligation to deliver cash or another financial asset means that it will not be possible for an instrument containing another liability element in addition to the put feature to be classified as equity. IAS 32 Clearly distinguishing liability and equity

Illustration – Right to require distributions under a partnership agreement

Partnership G is an incorporated partnership of civil engineers. Under the terms of the partnership agreement, the capital that a partner paid for a share in the partnership is repayable when he or she retires or leaves the partnership.

In addition to this right, a partnership share gives the partner a right at any time to:

  • require the partnership to distribute an amount equal to the partner’s pro rate share of the entity’s profits; and/or
  • require a distribution to cover the partner’s personal income tax liability arising from his share of the entity’s profits.

The existence of these additional contractual obligations means that it will not be possible to classify the partnership shares as equity.

IAS 32 Clearly distinguishing liability and equity IAS 32 Clearly distinguishing liability and equity IAS 32 Clearly distinguishing liability and equity

Illustration – Puttable instrument with obligation to pay dividends

Entity G has issued a class of share which gives the shareholder the right to put the share back to the entity. The shares entitle the holder to a minimum dividend of 5% per annum (based on the nominal value of the shares).

The shares cannot qualify for equity classification under the Amendments in their entirety as in addition to the put option there is also a contractual obligation to deliver cash to the holder due to the requirement to pay a minimum dividend.

5.1.5 Total expected cash flows attributable to the instrument over its life

The fifth condition to be met for a puttable instrument to achieve equity classification is: IAS 32 Clearly distinguishing liability and equity

“The total expected cash flows attributable to the instrument over the life of the instrument are based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity over the life of the instrument (excluding any effects of the instrument).” (IAS 32 16A(e))

The cash flows attributable to an instrument include: IAS 32 Clearly distinguishing liability and equity

  • the proceeds from the issue of the instrument; IAS 32 Clearly distinguishing liability and equity
  • returns on the instrument during its life (for example dividend payments);
  • the amount payable by the entity upon the instrument holder putting the instrument back to the entity.

The condition requires that the cash flows are substantially based on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity. IAS 1 and IAS 32 do not expand on what is meant by ‘substantially’ and judgement may be required to apply this condition. IAS 32 Clearly distinguishing liability and equity

Illustration – Cash flows based on a formula

Entity M issues an instrument which pays discretionary dividends based on the attributable profits of Entity M as a whole, and which is puttable at a proportionate share of 75% of the fair value of the unrecognised and recognised net assets of Entity M.

Does the instrument meet the condition in IAS 32 16A(e)?

In this example, the formula that determines the redemption price is based entirely on the change in the fair value of the recognised and unrecognised net assets of the entity. In our view this meets the applicable condition. It is not essential that the instrument receives 100% of the share of fair value of the recognised and unrecognised net assets of the Entity in order to meet the condition.

If, however, the return on redemption of the instrument had consisted of a fixed amount of CU 100,000 plus 75% of the proportionate share of the fair value of the recognised and unrecognised net assets of the Entity, then the IAS 32 16A(e) condition would be failed (assuming the CU 100,000 is ‘substantial’ in the context).

This is because the fixed payment of CU 100,000 means that the cash flows are no longer substantially derived from the change in the fair value of the recognised and unrecognised net assets of the entity.

It should be noted that the evaluation of the cash flow condition must take account of the expected cash flows from dividends as well as the amount payable on exercise of the put feature.

In relation to the underlying basis for the calculation of the cash flows, further explanation is as follows: Profit or loss and the change in the recognised net assets shall be measured in accordance with relevant IFRSs.” (IAS 32 AG 14E). IAS 32 Clearly distinguishing liability and equity

Another effect of the total expected cash flows condition is that a return based only on a specific part of an entity’s business will fail equity classification.

Illustration – Puttable shares in a mining company

A diversified mining company acquires a copper mine. As a result of the acquisition, it issues a class of puttable shares to the former owners of the copper mine. Dividends on this class of shares are discretionary. The amount payable by the entity when the holder chooses to exercise his put option will be determined by reference to the fair value of the mine at that time.

This instrument does not meet the condition in IAS 32 16A(e) as the return on redemption by the holder is based on the fair value of part of the entity’s business rather than the entity as a whole. The instruments will therefore be classified as financial liabilities.

5.1.6 No other financial instrument that is based on profit or loss or change in net assets of the entity and has the effect of fixing the residual return to the puttable instrument holders

The final condition to be met for a financial instrument to be classified as an equity instrument is that: IAS 32 Clearly distinguishing liability and equity

“in addition to the instrument having all the above features, the issuer must have no other financial instrument or contract that has:

  1. total cash flows based substantially on the profit or loss, the change in the recognised net assets or the change in the fair value of the recognised and unrecognised net assets of the entity (excluding any effects of such instrument or contract) and IAS 32 Clearly distinguishing liability and equity
  2. the effect of substantially restricting or fixing the residual return to the puttable instrument holders.” (IAS 32.16B)

For the purposes of applying this condition, only the cash flows and the contractual terms and conditions of the instrument that relate to the instrument holder as an owner of the entity are considered. Non-financial contracts with the holder of the instrument that may arise where the holder of the instrument is, say, also an employee of the entity should be ignored (provided the cash flows and contractual terms of the transaction are similar to those of an equivalent contract that might occur between a non-instrument holder and the issuing entity).

Illustration – Profit or loss sharing agreement based on services rendered

The partners in a professional services partnership hold puttable ‘partnership units’. The partners have entered into a profit sharing agreement that allocates profit or loss to the units based on business generated during the current year.

The profit sharing arrangement should not be considered when assessing whether the puttable instruments meet the conditions for equity classification. The profit sharing arrangement is a transaction with the instrument holders in their role as non-owners.

If the entity cannot determine that this ‘no other financial instrument’ condition is met, it shall not classify the puttable instrument as an equity instrument.

Examples

The following are example of ‘other financial instruments’ which, when entered into on normal commercial terms with unrelated parties, are unlikely to result in puttable instruments that otherwise meet the criteria for equity classification being classified as financial liabilities: IAS 32 Clearly distinguishing liability and equity

  • instruments with total cash flows substantially based on specific assets of the entity; IAS 32 Clearly distinguishing liability and equity
  • instruments with total cash flows based on a percentage of revenue; IAS 32 Clearly distinguishing liability and equity
  • contracts designed to reward individual employees for services rendered to the entity; IAS 32 Clearly distinguishing liability and equity
  • contracts requiring the payment of an insignificant percentage of profit for services rendered or goods provided (IAS 32 AG14J)

5.2.1 Other contractual obligations

The obligations arising on liquidation exception deals solely with those instruments that would under IAS 32’s normal principles be classified as financial liabilities because they contain an obligation to deliver a pro rata share of net assets on liquidation, and liquidation is either certain to occur or is uncertain but is at the option of the holder.

Consequently, the criteria relating to the obligations arising on liquidation exception does not include a condition that the instrument contains no other contractual obligations other than the obligation for the entity to deliver a pro rata share of its net assets on liquidation. This contrasts with the criteria for classification as equity under the puttable instruments exception ( see ‘5.1.4 No other contractual obligations to deliver cash or another financial asset’ above), which does contain such a condition.

As a result, the components of an instrument containing other contractual obligations may need to be accounted for separately in accordance with the normal requirements of IAS 32.

Illustration – Instrument with a contractual obligation in addition to an obligation arising on liquidation

Entity A is a limited life investment fund. It issues a class of instrument which entitles the holder to a pro rata share of the entity’s net assets on liquidation of the entity, which will be in ten years.

In addition to the obligation arising on liquidation, the instruments pay a fixed dividend amounting to CU 500,000 in each of the first three years of their ten year life.

The instrument therefore comprises different components which may need to be accounted for separately.

Application of the obligations arising on liquidation exception is only relevant to those obligations that exist at liquidation. The obligation to pay dividends in the first three years of the instrument’s life does not arise on liquidation and is therefore accounted for in accordance with the normal requirements of IAS 32. A financial liability is therefore recognised for the present value of the obligation to pay dividends of CU 500,000 per annum in the first three years.

Application of the obligations arising on liquidation exception is relevant to the feature of the instrument requiring payment of a pro rata share of the entity’s net assets on liquidation. If all of the criteria in the exception are met, this component of the instrument is classified as equity. If the criteria are not met, this component will be classified as a liability in accordance with the normal requirements of IAS 32.

5.2.2 No requirement to consider the expected total cash flows throughout the life of the instrument

Unlike the puttables exception, there is no requirement under the obligations arising on liquidation obligation rules for the total expected cash flows attributable to the instrument over its life to be based substantially on the profit or loss, the change in the recognised net assets or the change in fair value of the recognised and unrecognised net assets of the entity over the life of the instrument. IAS 32 Clearly distinguishing liability and equity

The reason for this difference is the timing of settlement of the obligation. The life of the financial instrument is the same as the life of the issuing entity, and extinguishment of the obligation can only occur at liquidation. The criteria for equity classification therefore focus only on the obligations that exist at liquidation.

5.2.3 The ‘identical features’ condition

For obligations arising on liquidation, the condition that all financial instruments in the most subordinate class have identical features is slightly different from the requirement relating to puttable instruments. It states that: IAS 32 Clearly distinguishing liability and equity

“All financial instruments in the class of instruments that is subordinate to all other classes of instruments must have an identical contractual obligation for the issuing entity to deliver a pro rata share of its net assets on liquidation.” (IAS 32 16C(c)) IAS 32 Clearly distinguishing liability and equity

It is possible then for an instrument within the most subordinate class of instruments to have different features from another instrument in that class as long as the entitlements on liquidation are the same. IAS 32 Clearly distinguishing liability and equity

Illustration – Differing voting rights prior to liquidation

An investment fund has two classes of share – A shares and B shares.

Both the A and the B shares give the holder the right to require the entity to enter into liquidation, upon which a pro rata share of net assets is repayable to the shareholders. Prior to liquidation, the only difference between the A and B shares is that the A shares entitle the shareholder to vote in general meeting. Upon liquidation, there are no differences between the rights of the A and B shares.

Does the difference between the voting rights of the A and B shares mean that neither can qualify for equity classification under the obligations arising on liquidation exception?

No. It is possible for the A and B shares to qualify for equity classification. The requirement under the obligations arising on liquidation exception is for all instruments in the most subordinated class to have an identical contractual obligation to deliver a pro rata share of net assets on liquidation. The differing voting rights of the A and B shares prior to liquidation are not relevant to this assessment.

5.3 Changes in classification

Because of the extensive conditions attached to equity classification of these types of instruments, the equity criteria could be met in some periods but failed in others.

Care is needed as an entity that has (correctly) classified a puttable instrument or an instrument with an obligation arising on liquidation as equity might, for example, subsequently issue another, more subordinated class of instruments. This would require the instrument to be reclassified as a liability.

Illustration – New class of redeemable shares issued

An investment fund has only one class of puttable shares (‘Class A’) which meet the criteria for equity classification.

The fund decides to issue another class of redeemable shares (‘Class B’). Class B shares are more subordinate than the Class A shares. What is the effect of this new issue on the classification on the existing class of redeemable shares?

IAS 32 16A(b) requires a puttable instrument to be in the most subordinate class of shares in order to be equity. The effect of issuing a new, more subordinated class of instruments is therefore that the Class A puttable instruments must be reclassified as financial liabilities. The Class B shares may be classified as equity instruments if all the applicable conditions are met.

In summary, reclassification of puttable instruments and obligations arising on liquidation are that: IAS 32 Clearly distinguishing liability and equity

  • an instrument is classified or reclassified into equity from the date it meets all of the applicable conditions;
  • the instrument is reclassified into liabilities if it ceases to meet all those conditions; IAS 32 Clearly distinguishing liability and equity
  • if an instrument is reclassified from liability to equity the amount transferred to equity is the carrying value of the financial liability at the date of reclassification;
  • if an instrument is reclassified from equity to liability, the initial carrying value of the liability is its fair value at the date of reclassification. Any difference between this fair value and the carrying value of the equity instrument is recorded in equity. IAS 32 Clearly distinguishing liability and equity

5.3.1 Non-controlling interests

As discussed above, some instruments that would otherwise be classified as liabilities being classified as equity, provided certain conditions are met. IAS 32 AG29A clarifies that these exceptions do not extend to the classification of non-controlling interests in consolidated financial statements. IAS 32 Clearly distinguishing liability and equity

Where for example a subsidiary classifies puttable instruments or instruments that impose an obligation only on liquidation as equity in its individual financial statements, any of those instruments held by non-controlling parties will not be presented as equity in the group’s consolidated financial statements.

The logic behind this rule is that if the group were to be liquidated, the claims of those non- controlling interests to the assets of the subsidiary would have to be met first ahead of those of the parent entity’s shareholders. This illustrates the potential for situations to exist where instruments are classified as equity in the single entity financial statements of a subsidiary but as liabilities at consolidated level. IAS 32 Clearly distinguishing liability and equity

5.3.2 Derivatives over puttable instruments and obligations arising on liquidation

Entities often issue or acquire derivatives over their own equity instruments such as warrants and share options. As discussed, derivatives over an entity’s own equity which meet the fixed for fixed test are treated as equity instruments. IAS 32 Clearly distinguishing liability and equity

Where the instruments to be received or delivered by the entity on settlement of a derivative contract are puttable financial instruments (or instruments with obligations arising on liquidation) the derivative is always a financial asset or liability. This is the case even if the underlying instruments would fall to be classified as equity in accordance with IAS 32 22A.

6 Compound financial instruments

Compound financial instruments contain elements which are representative of both equity and liability classification. IAS 32 Clearly distinguishing liability and equity

A common example is a convertible bond, which typically (but not always, see ‘6.2 Convertible bonds‘ below) consists of a liability component in relation to a contractual arrangement to deliver cash or another financial asset) and an equity instrument (a call option granting the holder the right, for a specified period of time, to convert the bond into a fixed number of ordinary shares of the entity).

Other examples of possible compound financial instruments include instruments with rights to a fixed minimum dividend and additional discretionary dividends, and instruments with fixed dividend rights but with the right to share in the residual net assets of the issuing entity on the entity’s liquidation.

6.1 Financial instruments with payments based on profits of the issuer

As discussed in ‘3.3.1 – C Financial instruments with payments based on profits of the issuer‘, an obligation to pay interest or dividends linked to profits of the issuer is a contractual obligation to deliver cash, which therefore meets the definition of a financial liability. IAS 32 Clearly distinguishing liability and equity

Some instruments that include such an obligation also include an equity component. For example, the contractual arrangements might make clear that the obligatory payments are a minimum and that additional, discretionary dividends might be paid. Such a feature meets the definition of an equity component since:

  • there is no obligation to deliver cash; and IAS 32 Clearly distinguishing liability and equity
  • it represents an interest in the residual assets of the issuer, after deducting all of the liabilities (IAS 32 11).

An equity component should be identified only if the discretionary feature has substance. It should not be presumed to exist (since, in theory, the issuer of any instrument could decide to make additional, discretionary payments). As with all financial instruments within the scope of IFRS 9, the liability should initially be recorded at its fair value. Subsequently, the instrument is measured in accordance with IFRS 9 at amortised cost, using the effective interest method or subject to the own-use exception at fair value through profit or loss.

6.2 Convertible bonds

Many convertible bonds are compound instruments. However, a common misconception is that a convertible bond is always a compound financial instrument. In fact, a convertible bond will only be a compound instrument where the component relating to conversion satisfies the requirements of the ‘fixed for fixed‘ test.

Illustration – Foreign currency denominated convertible debt

A UK company whose functional currency is pounds sterling issues a convertible bond which is denominated in US dollars.

The fact that the bond is denominated in a foreign currency means that the conversion component fails the fixed for fixed test, as a fixed amount of foreign currency is not considered to represent a fixed amount of cash ( see ‘4.6.1 Contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency‘ above).

The key is to carefully examine the terms of each financial instrument to determine whether separate components exist and, where they do, whether they are equity components or liability components. IAS 32 Clearly distinguishing liability and equity

The following table illustrates the importance of the ‘fixed for fixed’ test in relation to conversion rights:

Do conversion rights pass the ‘fixed for fixed’ test

Accounting requirements

Yes

  • Instrument is treated as a compound instrument
  • Liability and equity instruments split on inception
  • Equity element is not remeasured

No

  • Instrument is a hybrid instrument containing a host debt instrument with a conversion right (an embedded derivative) – see ‘6.5 Hybrid instruments‘ below.
  • The instrument is split on inception (unless the conversion option is closely related to the host instrument). Where split, both elements are carried as liabilities
  • Where separately recognised, the embedded derivative must be separately recognised at fair value through profit and loss

6.3 Split accounting for a compound financial instrument

IAS 32 requires the principle of substance over legal form to be applied in accounting for compound financial instruments. This involves separating the compound financial instrument into its separate components on initial recognition, a process which is often referred to as ‘split accounting’.

Taking the example of a convertible bond, split accounting is performed by first determining the carrying amount of the liability component. This is done by measuring the net present value of the discounted cash flows of interest and principal, ignoring the possibility of exercise of the conversion option. The discount rate is the market rate at the time of inception for a similar liability that does not have an associated equity component. IAS 32 Clearly distinguishing liability and equity

The carrying amount of the equity instrument represented by the conversion option is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole. IAS 32 Clearly distinguishing liability and equity

Illustration – Compound instrument – convertible bond

Entity A issues 1,000 convertible bonds on 1 July 2008 at par value of CU 1,000 each, giving CU 1m proceeds. The bonds have a three-year term and interest at 6% is paid annually in arrears. The bonds are convertible at the option of the holder, at any time until maturity, at a rate of 250 ordinary shares per bond. The prevailing market rate of similar bonds, without the conversion feature, is 9% per year.

The values of the liability and equity components are calculated as follows:

Amounts in CU

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

Present value of principal payable at the end of 3 years (CU 1m discounted at 9% for 3 years)

772,183

Present value of interest payable in arrears for 3 years (CU 60,000 discounted at 9% for each of 3 years)

151,878

Total liabilities component

924,061

Proceeds of bonds issue

1,000,000

Residual equity component

75,939

In subsequent years, the profit and loss account is charged with interest of 9% on the debt instrument. Assuming a June year-end the accounting effect may be summarised as follows, assuming in this case that the bond is redeemed for cash rather than converted at the end of its term:

Amounts in CU

Cash movement from issue/ interest/

redemption

Interest charge at 9%

Liability

Equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

IAS 32 Clearly distinguishing liability and equity

01/07/08

1,000,000

924,061

75,939

30/06/09

-60,000

83,165

947,226

75,939

30/06/10

-60,000

85,250

972,476

75,939

30/06/11 (pre redemption)

-60,000

87,524

1,000,000

75,939

30/06/11 (redemption)

-1,000,000

75,939

If the holder had exercised the option to convert at 30 June 2011, the carrying value at that time would have been transferred to equity rather than being repaid in cash (see IAS 32 AG32).

The split of the instrument between debt and equity and the amount of the respective components is determined on initial recognition and is not altered subsequently to reflect the likelihood of conversion of the instrument. IAS 32 Clearly distinguishing liability and equity

Another example of a compound instrument could be a non-redeemable preference share with an obligation to pay a contractual dividend but where in addition, there is also a contractual right to participate in further discretionary dividends. Such an instrument would be split accounted for as follows:

Illustration – Non-redeemable preference shares with obligation to pay dividends at less than market rates

Entity A issues 1,000 non-redeemable preference shares at par of CU 1 each, but the shares pay dividends of only 1% per annum (which is below the market rate of 8%). This amounts to an obligation to pay CU 10 per annum. In addition, the preference shares rank equally alongside ordinary shares in a winding up and the preference shares have voting rights. The preference shares also carry the possibility of discretionary dividends (ie in addition to the 1% obliged dividend/interest).

The CU 10 per annum dividend obligation meets the definition of a liability, but an equity component also exists as a result of the possibility of receiving discretionary dividends and participating in the net assets of the company should the company be liquidated. The shares are therefore compound financial instruments.

The liability component is based on the net present value at the time of inception of the CU 10 obligation for the annual dividend. This is calculated using the market rate of interest of 8% for a debt instrument without an equity component, giving CU 125 (CU 10 / 8%). The remainder of the proceeds received for issuing the shares would then be allocated to equity. The initial recognition of the transaction is:

Cash

CU

CU

Cash

1000

Financial liability non-redeemable preference shares debt

125

Equity share capital

875

The annual dividend/interest of CU is charged to profit or loss as interest expenses, any additional dividend is recorded within shareholders’ equity.

6.4 Compound instruments containing embedded non-equity derivatives

In the above example, the issuer does not have an option (at its discretion) to force early repayment. Such an option would be an embedded derivative (see definition, above).

Where a compound instrument contains another embedded derivative in addition to the holder’s conversion option, the value of the additional embedded derivative must be allocated to the financial liability component (IAS 32.31). This is done using the same principles as for a normal compound financial instrument – the liability component is established by measuring the value of a liability with similar terms (including the existence of a similar embedded derivative) but without the holder’s conversion option. IAS 32 Clearly distinguishing liability and equity

The equity component is then arrived at by deducting the liability component calculated above from the fair value of the instrument as a whole.

Having performed this calculation, a further assessment must be made of whether the embedded derivative is closely related to the host debt contract. This is in accordance with the normal requirements in IFRS 9 B4.3.2 for embedded derivatives to be accounted for separately if they are not considered to be closely related to the host contract. This assessment is made before separating the equity component. IAS 32 Clearly distinguishing liability and equity

6.5 Hybrid instruments

A financial instrument containing an embedded derivative which does not meet the definition of equity is referred to as a hybrid instrument.

Illustration – Foreign currency denominated convertible debt

The convertible debt instrument denominated in a foreign currency discussed in ‘6.2 Convertible bonds‘ is an example of a hybrid instrument.

The conversion component does not meet the definition of equity as a fixed amount of foreign currency is not considered to represent a fixed amount of cash (see ‘4.6.1 Contracts to be settled by a fixed number of own equity instruments in exchange for a fixed amount of foreign currency’, above). The term ‘hybrid instrument’ indicates that the instrument contains a host debt contract and an embedded derivative liability (the written call option over the entity’s own shares).

As in ‘6.4 Compound instruments containing embedded non-equity derivatives‘ above, an assessment of whether the embedded derivative is closely related to the host contract is required. Unless the embedded derivative is closely related to the host contract, it should be separated out from the host contract and measured at fair value. As an alternative, however, the entity may choose to fair value the entire instrument and so avoid the practical problems in having to separate out the embedded derivative component from the host contract.

6.6 Conversion of a convertible bond

On conversion of a convertible bond at maturity, the liability element relating to the convertible bond should be derecognised and recognised as equity. The original amount recognised in respect of the equity component remains in equity (although it may be transferred from one line item to another within equity). There is no gain or loss on conversion at maturity.

6.6.1 Early settlement of a convertible bond

When a convertible bond or other form of compound instrument is extinguished before its maturity date, the issuer should allocate the consideration and any transaction costs for the repurchase or redemption to the liability and equity components of the instrument at the date of settlement. IAS 32 Clearly distinguishing liability and equity

In allocating the consideration paid (and the transaction costs) to the separate components, the issuer applies the same method as for the original allocation of the issue proceeds to the liability and equity components. In other words, the issuer starts by allocating the settlement price to the remaining liability, and allocates the residual settlement amount to the equity component. It determines the fair value of the remaining liability using a discount rate that is based on circumstances at the settlement date. This may differ from the rate used for the original allocation.

Once this allocation has been performed, any resulting gain or loss should be treated in accordance with the accounting principles that apply to the related component.

This means that a loss is recorded in profit or loss to the extent that the amount of the consideration allocated to the liability component exceeds the carrying amount of the liability component at the date of early settlement (and vice versa). In contrast, the amount of consideration allocated to equity is recorded in equity. No gain or loss is recorded in respect of the equity component. Any remaining balance in relation to the equity component may be reclassified to another component of equity.

Illustration – Issuer settles convertible bond by early repayment

The details are the same as in the first example. However on 30 June 2010, Entity A tenders an offer of CU 1.1m (after the payment of the interest due on 30 June 2010) to the convertible bondholder to extinguish the liability and conversion rights, and the holder accepts.

IAS 32 requires that the amount paid (of CU 1.1m) is split by the same method as is used in the initial recording. However at 30 June 2010, the interest rate has changed. At that time, Entity A could have issued a one-year (ie maturity 30 June 2011) non-convertible bond at 5%. As set out in the earlier example 1, the carrying value of the liability at 30 June 2010 is CU 972,476.

The split of the CU 1.1m paid is as follows (Amounts in CU):

Present value of principal payable at 30/06/11 in one year’s time (CU 1m discounted at 5% for 1 year)

952,381

Present value of interest payable(CU 60,000 at 5% in one year’s time)

57,142

Total liability component

1,009,523

Proceeds – total fair value

1,100,000

Residual – equity component

90,477

The amount paid allocated to the liability element is CU 1,009,523. This compares to a book value of the liability at that date of CU 972,476, so a loss of CU 37,047 is reflected in the profit and loss account. The CU 90,477 of the “redemption” related to equity is debited to equity.

6.6.2 Amendment of the terms of a compound instrument to induce early conversion

An entity may amend the terms of a convertible instrument to induce early conversion, for example by offering a more favourable conversion ratio or paying other additional consideration in the event of conversion before a specified date.

Where this is the case, the difference between the fair value of the consideration the holder receives 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 profit or loss.

IAS 32 Clearly distinguishing liability and equity

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