IAS 32 Financial Instruments: Presentation outlines the accounting requirements for the presentation of financial instruments, particularly as to the classification of such instruments into financial assets, financial liabilities and equity instruments. The standard also provide guidance on the classification of related interest, dividends and gains/losses, and when financial assets and financial liabilities can be offset.
Liabilities and equity
The issuer of a financial instrument shall classify the instrument, or its component parts, 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.
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.
A puttable financial instrument includes a contractual obligation for the issuer to repurchase or redeem that instrument for cash or another financial asset on exercise of the put. As an exception to the definition of a financial liability, an instrument that includes such an obligation is classified as an equity instrument if it has all the following features:
- 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:
- dividing the entity’s net assets on liquidation into units of equal amount; and
- multiplying that amount by the number of the units held by the financial instrument holder.
- 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:
- has no priority over other claims to the assets of the entity on liquidation, and
- 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.
- 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.
- 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.
- 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).
Compound financial instruments
Some financial instruments – sometimes called compound instruments – have both a liability and an equity component from the issuer’s perspective. In that case, IAS 32 requires that the component parts be accounted for and presented separately according to their substance based on the definitions of liability and equity. The split is made at issuance and not revised for subsequent changes in market interest rates, share prices, or other event that changes the likelihood that the conversion option will be exercised.
To illustrate, a convertible bond contains two components. One is a financial liability, namely the issuer’s contractual obligation to pay cash, and the other is an equity instrument, namely the holder’s option to convert into common shares. Another example is debt issued with detachable share purchase warrants.
When the initial carrying amount of a compound financial instrument is required to be allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component.
The cost of an entity’s own equity instruments that it has reacquired (‘treasury shares’) is deducted from equity.
- Gain or loss is not recognised on the purchase, sale, issue, or cancellation of treasury shares.
- Treasury shares may be acquired and held by the entity or by other members of the consolidated group.
- Consideration paid or received is recognised directly in equity.
Interest, dividends, losses and gains
Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be recognised by the entity directly in equity. Transaction costs of an equity transaction shall be accounted for as a deduction from equity.
Offsetting a financial asset and a financial liability
IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It specifies that a financial asset and a financial liability should be offset and the net amount reported when, and only when, an entity:
- has a legally enforceable right to set off the amounts; and
- intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
Costs of issuing or reacquiring equity instruments
Costs of issuing or reacquiring equity instruments are accounted for as a deduction from equity, net of any related income tax benefit.