Best focus on IAS 32 Equity and Financial Liabilities

IAS 32 Equity and Financial Liabilities

have to be distinguished by an issuer of more complex financial instruments

For many (most!), simpler financial instruments the classification as a financial liability or equity works well. So, classifying more complex financial instruments under IAS 32 – e.g. those with characteristics of equity – can be more challenging, leading to diversity in practice. IAS 32 Equity and Financial Liabilities

IFRS References: IAS 1, IAS 32, IFRS 9, IFRIC 17

IN SHORT to check off

An instrument, or its components, is classified on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument.

A financial instrument is a financial liability if it contains a contractual obligation to transfer cash or another financial asset.

IAS 32 Equity and Financial Liabilities

A financial instrument is also classified as a financial liability if it is a derivative that will or may be settled in a variable number of the entity’s own equity instruments or a non-derivative that comprises an obligation to deliver a variable number of the entity’s own equity instruments.

An obligation for an entity to acquire its own equity instruments gives rise to a financial liability, unless certain conditions are met.

As an exception to the general principle, certain puttable instruments and instruments, or components of instruments, that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation are classified as equity instruments if certain conditions are met.

The contractual terms of preference shares and similar instruments are evaluated to determine whether they have the characteristics of a financial liability.

The components of compound financial instruments, which have both liability and equity characteristics, are accounted for separately.

A non-derivative contract that will be settled by an entity delivering its own equity instruments is an equity instrument if, and only if, it will be settled by delivering a fixed number of its own equity instruments.

A derivative contract that will be settled by the entity delivering a fixed number of its own equity instruments for a fixed amount of cash is an equity instrument. If such a derivative contains settlement options, then it is an equity instrument only if all settlement alternatives lead to equity classification.

Incremental costs that are directly attributable to issuing or buying back own equity instruments are recognised directly in equity.

Treasury shares are presented as a deduction from equity.

Gains and losses on transactions in an entity’s own equity instruments are reported directly in equity.

Dividends and other distributions to the holders of equity instruments, in their capacity as owners, are recognised directly in equity.

NCI are classified within equity, but separately from equity attributable to shareholders of the parent.

Classification as a financial liability or equityPuttable instruments

General principles

An instrument is a financial liability if it is:

  • a contractual obligation: IAS 32 Equity and Financial Liabilities
    • to deliver cash or other financial assets; or IAS 32 Equity and Financial Liabilities
    • to exchange financial assets or financial liabilities with another entity under potentially unfavourable conditions (for the issuer of the instrument); or IAS 32 Equity and Financial Liabilities
  • a contract that will or may be settled in the entity’s own equity instruments and is:
    • a non-derivative that comprises an obligation for the entity to deliver a variable number of its own equity instruments; or
    • a derivative that will or may be settled other than by the entity exchanging a fixed amount of cash or other financial assets for a fixed number of its own equity instruments. [IAS 32.11]

Any instrument that an issuer could be obliged to settle in cash, or by delivering other financial assets, is a financial liability regardless of the financial ability of the issuer to settle the contractual obligation or the probability of settlement. [IAS 32.19]

An obligation for an entity to acquire its own equity instruments (e.g. a forward contract to buy its own shares or a written put option on own shares) gives rise to a financial liability, unless they meet the conditions set out below in the sections on ‘puttable instruments’ and ‘obligations arising on liquidation’ to be classified as equity. This is the case even if the contract itself is an equity instrument. [IAS 32.23] IAS 32 Equity and Financial Liabilities

In general, an ‘equity instrument’ is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. [IAS 32.11] IAS 32 Equity and Financial Liabilities

An equity instrument is an instrument that meets both of the following conditions:

  • There is no contractual obligation to deliver cash or another financial asset to another party, or to exchange financial assets or financial liabilities with another party under potentially unfavourable conditions (for the issuer of the instrument).
  • If the instrument will or may be settled in the issuer’s own equity instruments, then it is either:
    • a non-derivative that comprises an obligation for the issuer to deliver a fixed number of its own equity instruments; or
    • a derivative that will be settled only by the issuer exchanging a fixed amount of cash or other financial assets for a fixed number of its own equity instruments. [IAS 32.11, IAS 32.16]

An obligation may arise from a requirement to repay principal or to pay interest or dividends. A perpetual instrument with an obligation to pay dividends or interest is a liability and the principal is assumed to be equal to the net present value of the dividend or interest obligation. [IAS 32.AG6] IAS 32 Equity and Financial Liabilities

Instruments or components of instruments are either a liability or equity; there is no midway classification between liabilities and equity. [IAS 32.15–16] IAS 32 Equity and Financial Liabilities

The classification of an instrument as either a financial liability or equity is made on initial recognition. However, a reclassification may be required if: IAS 32 Equity and Financial Liabilities

  • an entity amends the contractual terms of an instrument;
  • the effective terms of an instrument change without any amendment of the contractual terms;
  • there is a relevant change in the composition of the reporting entity; or
  • in the case of puttable instruments and instruments that impose on the entity an obligation only on liquidation, if certain conditions are met. [IAS 32.15, IAS 32.16E]
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Contingent settlement provisions

An instrument that contains contingent settlement provisions is a financial liability because the issuer does not have thePuttable instruments unconditional right to avoid making payments unless one of the following applies:

  • the part of the contingent settlement provision that could require settlement in cash or another financial asset is not genuine; or IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities
  • the issuer can be required to settle in cash or another financial asset only in the event of its own liquidation. [IAS 32.25]

Puttable instruments

A ‘puttable instrument’ is a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset or is automatically put back to the issuer on the occurrence of an uncertain future event or the death or retirement of the holder. Puttable instruments are generally classified as financial liabilities of the issuer, unless certain conditions are met. [IAS 32.16A] IAS 32 Equity and Financial Liabilities

A puttable instrument is classified as equity if all of the following conditions are met:

  • the instrument entitles the holder to a pro-rata share of the entity’s net assets in the event of the entity’s liquidation;
  • the instrument belongs to a class of instruments that is subordinated to all other classes of instruments issued by the entity. In determining whether an instrument is in the most subordinated class, an entity evaluates the instrument’s claim on liquidation as if it were to liquidate on the date when it classifies the instrument;
  • all financial instruments in this most subordinated class of instruments have identical features (i.e. no instrument holder in that class can have preferential terms or conditions); IAS 32 Equity and Financial Liabilities
  • apart from the contractual obligation to repurchase or redeem the instrument, the instrument does not include any other 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
  • the total expected cash flows attributable to the instrument over its life 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. Profit or loss and the change in recognised net assets are measured in accordance with IFRS Standards for this purpose. [IAS 32.16A, IAS 32.AG14A–AG14E]

In addition to the above conditions to be met by the instrument, the issuer must not have any other financial instrument or contract that has: IAS 32 Equity and Financial Liabilities

  • 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; and
  • the effect of substantially restricting or fixing the residual return to the puttable instrument holders. [IAS 32.16B]

Obligations arising on liquidation

Some financial instruments include a contractual obligation for the issuing entity to deliver to another entity a pro rata share of its net assets only on liquidation. The obligation arises because liquidation either is certain to occur and is outside the control of the entity – e.g. a limited-life entity – or is uncertain to occur but is at the option of the instrument holder. Such instruments are classified as equity if certain conditions are met (see below). [IAS 32.16C]

As an exception to the definition of a financial liability, an instrument (or a component of an instrument) that includes such an obligation is classified as equity if it has all of the following features: IAS 32 Equity and Financial Liabilities

  • the instrument entitles the holder to a pro-rata share of the entity’s net assets in the event of the entity’s liquidation;
  • the instrument belongs to a class of instruments that is subordinated to all other classes of instruments issued by the entity. In determining whether an instrument is in the most subordinated class, an entity evaluates the instrument’s claim on liquidation as if it were to liquidate on the date when it classifies the instrument; and
  • all financial instruments in this most subordinated class of instruments have an identical contractual obligation for the entity to deliver a pro rata share of its net assets on liquidation. [IAS 32.16C, IAS 32.AG14B]

In addition to the instrument having all of the above features to be classified as an equity instrument, the issuer must have no other financial instrument or contract that has: IAS 32 Equity and Financial Liabilities

  • 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; and
  • the effect of substantially restricting or fixing the residual return to the instrument holders. [IAS 32.16D]

Impact of share settlement

Setting the scene: the Expected Credit Losses modelIf a non-derivative contract comprises a contractual obligation to deliver a variable number of the entity’s own equity instruments, then it is a liability. [IAS 32.11, IAS 32.16(b)(i), IAS 32.21, IAS 32.AG27(d)]

If a derivative contract will be settled only by the entity receiving or delivering a fixed number of own equity shares for a fixed amount of cash or another financial asset, then it is an equity instrument of the entity. [IAS 32.11, IAS 32.16(b)(ii)]

If a derivative financial instrument gives one party a choice over how it is settled – e.g. the issuer or the holder can choose settlement net in cash or by exchanging shares for cash – then it is a financial asset or financial liability unless all of the settlement alternatives result in it being an equity instrument. [IAS 32.26] IAS 32 Equity and Financial Liabilities

Equity instruments include options and warrants on an entity’s own equity if they meet certain conditions. [IAS 32.11, IAS 32.16(b)(ii)] IAS 32 Equity and Financial Liabilities

A contract that will be settled by the entity receiving or delivering a fixed or variable number of puttable instruments, or instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation, is a financial asset or a financial liability. [IAS 32.11] IAS 32 Equity and Financial Liabilities

Redemption options

An instrument may be redeemable at the option of the issuer but, through its terms and conditions, may establish an obligation indirectly for the issuer to transfer cash or other financial instruments to the holder. In such cases, the instrument is a liability. [IAS 32.20] IAS 32 Equity and Financial Liabilities

Classification of rights issues

Rights (and similar derivatives) to acquire a fixed number of an entity’s own equity instruments for a fixed price stated in a currency other than the entity’s functional currency are equity instruments, provided that the entity offers the rights pro-rata to all of its existing owners of the same class of its non-derivative equity instruments. [IAS 32.16(b)(ii)]

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Compound instruments

An instrument that contains both liability and equity elements – e.g. a convertible bond or convertible preference shares – is a compound instrument. Compound instruments are allocated between their liability and equity components (split accounting). [IAS 32.28–29, IAS 32.AG31] IAS 32 Equity and Financial Liabilities

The carrying amount of a compound instrument is allocated between its liability and equity components on initial recognition as follows. IAS 32 Equity and Financial Liabilities

  • The amount allocated to the liability element is its fair value determined with reference to a similar stand-alone debt instrument including any embedded non-equity derivatives.
  • The remaining issue proceeds are allocated to the equity element. [IAS 32.31–32]

On early redemption of a convertible instrument, the redemption payment is allocated to the liability and equity components using the method initially used to allocate the instrument between its liability and equity components. [IAS 32.AG33]

Accounting for conversion at maturity

On conversion of a compound instrument, the entity derecognises the liability component, which is extinguished when the conversion feature is exercised, and recognises that amount as equity. The original equity component remains as equity. No gain or loss is recognised in profit or loss. Most commonly and after applying judgement, this accounting applies even if the conversion feature is exercised before the liability’s maturity date (i.e. in the case of an American-style feature). [IAS 32.AG32]

Recognition and measurement

The recognition and measurement of financial liabilities is discussed in ‘Classification of financial liabilities and ‘Recognition and derecognition‘. The remainder of this narrative focuses on equity. IAS 32 Equity and Financial Liabilities

IFRS Standards do not have any specific measurement requirements related to equity, other than in respect of splitting compound instruments, the cost of equity transactions, treasury shares and equity instruments that are issued in share-based payment transactions (see ‘Share-based payments‘). [IFRS 9.2.1(d)] IAS 32 Equity and Financial Liabilities

An entity may be owed an amount in respect of a contribution for new equity shares that have already been issued. Commonly, the equity and a corresponding receivable are recognised if the receivable meets the definition of a financial asset. This requires the entity to have a contractual right to receive the amount at the reporting date. A ‘contractual right’ is more than an informal agreement or a non-contractual commitment. IAS 32 Equity and Financial Liabilities

As a general principle, the definitions of income and expenses exclude transactions with holders of equity instruments acting in thatContext Fair value capacity. Therefore, gains or losses on transactions in the entity’s own equity are not recognised in profit or loss. The effects of transactions with owners are recognised in equity. However, derivatives on own equity that are classified as assets or liabilities (see above) result in gains and losses recognised in profit or loss. IAS 32 Equity and Financial Liabilities

There is no specific guidance under IFRS Standards on how to account for an issue of bonus shares to shareholders or distribution of shares in lieu of dividends (with or without a cash alternative). However, in practice the following accounting is used in practice:

  • in the case of a simple split of shares or a bonus issue, there is no requirement to adjust total equity or an individual component of equity (however, the laws of the country of incorporation may require a reallocation of capital within equity);
  • when shares with a value equal to the cash dividend amount are offered as an alternative to the cash dividend, it is acceptable to debit the liability and recognise a credit to equity as the proceeds of the issue; and
  • when a share dividend is not an alternative to cash dividend, no accounting entries are required.

Treasury shares

Any amounts paid by an entity to acquire its own shares are debited directly to equity. This applies whether the shares are cancelled immediately or held for resale – i.e. treasury shares. Amounts received from the sale of treasury shares are credited directly to equity. No gains or losses are recognised in profit or loss on any transactions in own shares and changes in the value of treasury shares are not recognised, even if these shares are held for trading purposes. [IAS 32.33, IAS 32.AG36]

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Own shares held in connection with an equity compensation plan held by the entity are presented as treasury shares. [IAS 32.4(f), IAS 32.33–34] IAS 32 Equity and Financial Liabilities

Treasury shares, including those held for trading purposes, are not recognised as assets or measured at fair value with gains and losses recognised in profit or loss. [IAS 32.33, IAS 32.AG36]

An associate may have an investment in its investor. IFRS Standards do not provide specific guidance on whether the carrying amount of the associate under the equity method should include the investor’s share of the associate’s investment in the investor’s own shares. However, the investor is not required to make any adjustments. [IAS 1.79, IAS 32.33]

Cost of an equity transaction

Qualifying costs attributable to an equity transaction – e.g. issuing or buying back own equity instruments – are debited directly to equity. [IAS 32.35, IAS 32.37] IAS 32 Equity and Financial Liabilities

A listing of existing shares, a secondary offering and share splits do not result in new equity instruments being issued; therefore, any costs associated with such transactions are expensed as they are incurred. [IAS 32.35, IAS 32.38]

Equity presentation

There are no specific requirements in IFRS Standards on how to present the individual components of equity. See ‘Other comprehensive income‘ for a description of items that are presented in OCI.

NCI are presented within equity separately from equity of the parent’s shareholders. [IAS 1.54, IAS 1.106, IFRS 10.22]

Dividends

Dividends and other distributions to holders of equity instruments are recognised directly in equity. [IAS 32.35]

A liability for dividends is not recognised until the entity has an obligation to pay dividends, which is generally not until they are declared or approved, if approval is required (see Events after the reporting date‘). [IAS 10.12]

Dividends on shares that are liabilities are recognised in profit or loss as a financing cost, even if the legal form of the payment is a dividend, unless the dividends are discretionary. Financing costs on shares that are liabilities are determined using the effective interest method (see ‘Measurement‘). [IAS 32.35] IAS 32 Equity and Financial Liabilities

Distributions of non-cash assets to owners

There is specific guidance in respect of non-reciprocal distributions to shareholders in which all shareholders of the same class are treated equally; however, the guidance does not apply to common control transactions or to distributions of part of the ownership interests in a subsidiary when control is retained (see ‘Common control and Newco formations‘). [IFRIC 17.3–7]

Distributions in the scope of the guidance, including spin-offs and demergers (see Consolidation‘), are accounted for on a fair value basis and any gain, representing the excess of the fair value of the assets distributed over their book value, is recognised in profit or loss on the date of settlement. [IFRIC 17.14] IAS 32 Equity and Financial Liabilities

Also read: IAS 32 Equity and Financial Liabilities

IAS 32 Equity and Financial Liabilities

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IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities  IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities

IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities IAS 32 Equity and Financial Liabilities

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