made in arriving at the result for a particular period. Liabilities, such as loan finance, on
the other hand, are remunerated by interest, which is charged to profit or loss as an
expense. In general, lenders rank before shareholders in priority of claims over the
assets of the company, although in practice there may also be differential rights between
different categories of lenders and classes of shareholders. The two forms of finance
often have different tax implications, both for the investor and the investee.
In economic terms, however, the distinction between share and loan capital can be far
less clear-cut than the legal categorisation would suggest. For example, a redeemable
preference share could be considered to be, in substance, much more like a liability than
equity. Conversely, many would argue that a bond which can never be repaid but which
will be mandatorily converted into ordinary shares deserves to be thought of as being
more in the nature of equity than of debt, even before conversion has occurred.
The ambiguous economic nature of such instruments has encouraged the development
of a number of complex forms of finance which exhibit characteristics of both equity
and debt. The ‘holy grail’ is generally to devise an instrument regarded as a liability by
the tax authorities (such that the costs of servicing it are tax-deductible) but treated as
equity for accounting and/or regulatory purposes (so that the instrument is not
considered as a component of net borrowings).
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The accounting classification of an instrument as a liability or equity is much more than
a matter of allocation – i.e. where particular amounts are shown in the financial
statements. The requirement of IFRS for certain liabilities, in particular derivatives, to
be carried at fair value means that the classification of an item as a liability can introduce
significant volatility into reported results, that would not arise if the item were classified
as an equity instrument. This is due to the fact that changes in the fair value of an equity
instrument are not recognised in the financial statements. [IAS 32.36].
Moreover, the extent to which an entity funds its operations through debt or equity is
regarded as highly significant not only by investors, but also by other users of financial
statements such as regulators and tax authorities. This means that the question of
whether a particular instrument is a liability or equity raises issues of much greater and
wider sensitivity than the mere matter of financial statement classification.
1.2
Development of IFRS on classification of liabilities and equity
Under IFRS, the classification of items as liabilities or equity is dealt with mainly in
IAS 32 – Financial Instruments: Presentation – with some cross-reference to IFRS 9 –
Financial Instruments.
IAS 32 was originally issued in March 1995 and subsequently amended in 1998 and
2000. However, in December 2003, the previous version of IAS 32 was withdrawn and
superseded by a new version, which has itself been amended by subsequent new
pronouncements, most notably IFRS 7 – Financial Instruments: Disclosures (see
Chapter 50) and the amendment to IAS 32 – Puttable Financial Instruments and
Obligations Arising on Liquidation.
The main text of IAS 32 is supplemented by application guidance (which is an integral
part of the standard),1 and by illustrative examples (which accompany, but are not part
of, the standard).2
The Interpretations Committee has issued two interpretations of IAS 32 discussed in
this chapter:
• IFRIC 2 – Members’ Shares in Co-operative Entities and Similar Instruments
(see 4.6.6 below); and
• IFRIC 19 – Extinguishing Financial Liabilities with Equity Instruments (see 7 below).
A joint attempt of the IASB and the FASB to develop a new model, in which
classification of an instrument was based on whether the instrument would be settled
with assets or with equity instruments of the issuer, was suspended in October 2010
due to significant challenges raised by a small group of external reviewers of a draft
exposure draft.
In October 2014 the IASB resumed the Financial Instruments with Characteristics of
Equity Research Project to explore further how to distinguish liabilities from equity
claims. The IASB is considering various aspects of the definition, presentation and
disclosure of liabilities and equity and issued a Discussion Paper (the FICE DP) in
June 2018 (see 12 below).
Financial instruments: Financial liabilities and equity 3491
2
OBJECTIVE AND SCOPE
2.1 Objective
The objective of IAS 32 is ‘to establish principles for presenting financial instruments as
liabilities or equity and for offsetting financial assets and financial liabilities.’ [IAS 32.2].
The standard, and its associated IFRIC interpretations, address:
• the classification of financial instruments, by their issuer, into financial assets,
financial liabilities and equity instruments (see 3 to 6 below);
• settling a financial liability with an equity instrument (see 7 below);
• the classification of interest, dividends, losses and gains (see 8 below);
• treasury shares – i.e. an entity’s own equity instruments held by the entity (see 9 below);
• forward contracts or options for the receipt or delivery of the entity’s own equity
instruments (see 11 below); and
• the circumstances in which financial assets and financial liabilities should be offset
(see Chapter 50 at 7.4.1).
The principles in IAS 32 complement the principles for recognising and measuring
financial assets and financial liabilities in IFRS 9, and for disclosing information about
them in IFRS 7. [IAS 32.3].
2.2 Scope
The scope of IAS 32 is discussed in detail in Chapter 41 at 3.
3 DEFINITIONS
The following definitions in IAS 32 are relevant to the issues discussed in this chapter.
Further general discussion on the meaning and implications of the definitions may be
found in Chapter 41 at 2.
A financial instrument is any contract that gives rise to a financial asset of one entity and
a financial liability or equity instrument of another entity. [IAS 32.11].
A financial asset is any asset that is:
(a) cash;
(b) an equity instrument of another entity;
(c) a
contractual
right:
(i) to receive cash or another financial asset from another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
(d) a contract that will or may be settled in the entity’s own equity instruments and is:
(i)
a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
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own equity instruments. For this purpose the entity’s own equity instruments
do not include:
�
� puttable financial instruments classified as equity instruments in
accordance with paragraphs 16A and 16B of the standard (see 4.6.2 below);
• 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
and are classified as equity in accordance with paragraphs 16C and 16D
of the standard (see 4.6.3 below); or
• instruments that are contracts for the future receipt or delivery of the
entity’s own equity instruments. [IAS 32.11].
A financial liability is any liability that is:
(a) a
contractual
obligation:
(i) to deliver cash or another financial asset to another entity; or
(ii) to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
(b) a contract that will or may be settled in the entity’s own equity instruments and is:
(i)
a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity’s own equity instruments; or
(ii) a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity’s
own equity instruments. For this purpose, rights, options or warrants to
acquire a fixed number of the entity’s own equity instruments for a fixed
amount of any currency are equity instruments if the entity offers the rights,
options or warrants pro rata to all of its existing owners of the same class of
its own non-derivative equity instruments. Also, for these purposes the
entity’s own equity instruments do not include:
• puttable financial instruments classified as equity instruments in
accordance with paragraphs 16A and 16B of the standard (see 4.6.2
below);
• 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
and are classified as equity in accordance with paragraphs 16C and 16D
of the standard (see 4.6.3 below); or
• instruments that are contracts for the future receipt or delivery of the
entity’s own equity instruments. [IAS 32.11].
As an exception to the general definition of a financial liability, an instrument that meets
the definition of a financial liability is nevertheless classified as an equity instrument if
it has all the features and meets the conditions in paragraphs 16A and 16B (see 4.6.2
below) or paragraphs 16C and 16D of the standard (see 4.6.3 below). [IAS 32.11].
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
Financial instruments: Financial liabilities and equity 3493
back to the issuer on the occurrence of an uncertain future event or the death or
retirement of the holder. [IAS 32.11].
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].
A derivative is a financial instrument or other contract within the scope of IFRS 9 (see
Chapter 42 at 2) 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 of 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; and
• it is settled at a future date. [IFRS 9 Appendix A].
Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.
[IAS 32.11]. This is the same definition as used in IFRS 13 – Fair Value Measurement (see
Chapter 14 at 3).
In these definitions (and throughout IAS 32 and the discussion in this chapter):
• 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;
[IAS 32.13]
• Entity includes individuals, partnerships, incorporated bodies, trusts and
government agencies. [IAS 32.14].
4 CLASSIFICATION
OF
INSTRUMENTS
The most important issue dealt with by IAS 32 is the classification of financial
instruments (or their components) by their issuer as financial liabilities, financial assets
or equity instruments, including non-controlling interests. The rule in IAS 32 for
classification of items as financial liabilities or equity is essentially simple. An issuer of a
financial instrument must 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 (see 3 above). [IAS 32.15]. The
application of this principle in practice, however, is often far from straightforward.
IAS 32 considers the question of whether a transaction is a financial liability or an equity
instrument at two levels. First it examines whether an individual instrument (or class of
instruments) issued by the entity is a financial liability or equity. This is principally
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discussed in this section, although some of the provisions discussed at 5 and 6 below
may also be relevant.
Second, where an entity settles a transaction using instruments issued by it that, when
considered in isolation, would be classified as equity, IAS 32 requires the entity to
consider whether the transaction considered as a whole is in fact a financial liability.
This will typically be the case where a transaction is settled by issuing a variable number
of equity instruments equal to an agreed value. This is principally discussed at 5 and 6
below, although some of the provisions discussed here at 4 may also be relevant.
The appropriate classification is made on initial recognition of the instrument and, in
general, not changed subsequently (see 4.9 below on reclassification of instruments).
4.1
Definition of equity instrument
Application of the basic definitions in IAS 32 means that an instrument is an equity
instrument only if both the following conditions are met:
• The instrument includes no contractual obligation either:
• 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 is
suer.
• If the instrument will, or may, be settled in the issuer’s own equity instruments, it
is either:
• a non-derivative that includes no contractual obligation for the issuer to
deliver a variable number of its own equity instruments; or
• a derivative that will be settled only by the issuer exchanging a fixed amount
of cash or another financial asset for a fixed number of its own equity
instruments. For this purpose the issuer’s own equity instruments do not
include instruments that have all the features and meet the conditions
described in paragraphs 16A and 16B (see 4.6.2 below) or paragraphs 16C and
16D (see 4.6.3 below) of IAS 32 or instruments that are contracts for the future
receipt or delivery of the issuer’s own equity instruments. [IAS 32.16].
As a pragmatic exception to these basic criteria, an instrument that would otherwise
meet the definition of a financial liability is nevertheless classified as an equity
instrument if it is either:
• a puttable instrument with all the features, and meeting the conditions described,
in paragraphs 16A and 16B of IAS 32 (see 4.6.2 below); or
• an instrument entitling the holder to a pro-rata share of assets on a liquidation with
all the features, and meeting all the conditions, described in paragraphs 16C and
16D of IAS 32. [IAS 32.16]. This is discussed further at 4.6.3 below.
Broadly speaking, apart from this exemption, an instrument can only be classified as equity
under IAS 32 if the issuer has an unconditional right to avoid delivering cash or another
financial instrument (see 4.2 below) or, if it is settled through the entity’s own equity
instruments, it is for an exchange of a fixed amount of cash for a fixed number of the entity’s
own equity instruments. In all other cases it would be classified as a financial liability.
Financial instruments: Financial liabilities and equity 3495
4.2
Contractual obligation to deliver cash or other financial assets
It is apparent from 4.1 above that a critical feature in differentiating a financial liability
from an equity instrument is the existence of a contractual obligation of one party to the
financial instrument (the issuer) either:
• to deliver cash or another financial asset to the other party (the holder); or
• to exchange financial assets or financial liabilities with the holder under conditions
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