IAS 32

IAS 32: Financial Instruments: Presentation

IAS 32 Financial Instruments: Presentation sets out the principles for presenting financial instruments as financial assets, financial liabilities or equity instruments. The standard also provide guidance on the classification of related interest, dividends and gains/losses, and and when financial assets and financial liabilities can be offset.

IAS 32 is a companion to IFRS 9 Financial Instruments. IFRS 9 deal with initial recognition of financial assets and liabilities, measurement subsequent to initial recognition, impairment, derecognition, and hedge accounting.

Scope

IAS 32 applies in presenting and disclosing information about all types of financial instruments with the following exceptions:

• Interests in subsidiaries, associates and joint ventures that are accounted for under IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements and IAS 28 Investments in Associates and Joint Ventures. However, IAS 32 applies to all derivatives on interests in subsidiaries, associates, or joint ventures.
• Employers’ rights and obligations under employee benefit plans.
• Insurance contracts(see IFRS 4 Insurance Contracts)
• Financial instruments that are within the scope of IFRS 4 because they contain a discretionary participation feature are only exempt from applying paragraphs 15-32 and AG25-35 (analysing debt and equity components) but are subject to all other IAS 32 requirements.
• Contracts and obligations under share-based payment transactions (see IFRS 2 Share-based Payment) with the following exceptions:
  • This standard applies to contracts within the scope of IAS 32.8-10
  • Paragraphs 33-34 apply when accounting for treasury shares purchased, sold, issued or cancelled by employee share option plans or similar arrangements
• IAS 32 applies to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, except for contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity’s expected purchase, sale or usage requirements.

Key definitions

Financial instrument

A contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity.

Financial asset

Any asset that is:

• cash
• an equity instrument of another entity
• a contractual right
  • to receive cash or another financial asset from another entity; or
  • to exchange financial assets or financial liabilities with another entity under conditions that are potentially favourable 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 receive a variable number of the entity’s own equity instruments
  • 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
  • puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments

IAS 32 makes it clear that the following items are not financial instruments.

• Physical assets, eg, inventories, property, plant and equipment, leased assets and intangible assets (patents, trademarks, etc)
• Prepaid expenses, deferred revenue and most warranty obligations
• Liabilities or assets that are not contractual in nature
• Contractual rights/obligations that do not involve transfer of a financial asset, e.g., commodity futures contracts

Financial liability

Any liability that 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; puttable instruments classified as equity or certain liabilities arising on liquidation classified by IAS 32 as equity instruments

The key to this definition is that a financial liability is a contractual obligation to deliver cash or another financial asset, or a contractual obligation to exchange financial assets or liabilities on potentially unfavourable terms.

Examples of financial liabilities include trade payables, loans and redeemable preference shares. A bank overdraft is a financial liability as it is repayable in cash. A warranty provision would not be a financial liability because the obligation is to deliver additional goods or services, not cash.

Equity instrument

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

Holders of ordinary shares in a company own equity instruments. Although they own the residual interest in a company, they have no contractual right to demand any of it to be delivered to them, for example by way of a dividend. Equally, the company has issued an equity instrument, not a financial liability, because the company has no contractual obligation to distribute the residual interest.

An entity that invests in the ordinary shares of another entity holds a financial asset, because an equity interest in another entity falls within the definition of a financial asset.

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.

Derivative

A derivative is a financial instrument or other contract (such as an option) 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
• It is settled at a future date.

Fair value

The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Puttable instrument

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 occurrence of an uncertain future event or the death or retirement of the instrument holder.

Classification as liability or equity

The fundamental principle of IAS 32 is that a financial instrument should be classified as either a financial liability or an equity instrument according to the substance of the contract, not its legal form, and the definitions of financial liability and equity instrument.

Two exceptions from this principle are certain puttable instruments meeting specific criteria and certain obligations arising on liquidation. The entity must make the decision at the time the instrument is initially recognised. The classification is not subsequently changed based on changed circumstances.

A financial instrument is an equity instrument only if (a) the instrument includes no contractual obligation to deliver cash or another financial asset to another entity and (b) if the instrument will or may be settled in the issuer’s own equity instruments, and 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.

Preference shares

Preference shares provide the holder with the right to receive an annual dividend (usually of a predetermined and unchanging amount) out of the profits of a company, together with a fixed amount on the ultimate liquidation of the company or at an earlier date if the shares are redeemable. The legal form of the instrument is equity.

IAS 32 treats most preference shares as liabilities. This is because they are, in substance, loans

• Fixed annual dividend = ‘interest’
• Fixed amount on redemption/liquidation = ‘repayment of loan’

In substance the fixed level of dividend is interest and the redemption amount is a repayment of a loan. Because financial reporting focuses on the substance of the transactions, redeemable preference shares should be presented as liabilities.

However, where preference shares are not redeemable at the option of the preference shareholder they are known as irredeemable preference shares and the classification depends on other terms related to the preference shares, such as the rights to dividends.

If dividends on the irredeemable preference shares are mandatory and cumulative, then the entity has a contractual obligation to pay the dividends to the preference shareholders and therefore the shares should be presented as liabilities.

If there is no mandatory requirement to pay (or defer) dividends on irredeemable preference shares ie, the payment of dividends is discretionary, then there is no contractual obligation to deliver cash (or another financial asset) and instead the irredeemable preference shares should be presented as equity.

Therefore in practical terms preference shares are only treated as part of equity when:

• They will never be redeemed;
• The redemption is solely at the option of the issuer and the terms are such that it is very unlikely at the time of issue that the issuer will ever decide on redemption; and
• The payment of dividends is discretionary.

Contingent settlement provisions

If, as a result of contingent settlement provisions, the issuer does not have an unconditional right to avoid settlement by delivery of cash or other financial instrument (or otherwise to settle in a way that it would be a financial liability) the instrument is a financial liability of the issuer, unless:

• The contingent settlement provision is not genuine or
• The issuer can only be required to settle the obligation in the event of the issuer’s liquidation or
• The instrument has all the features and meets the conditions of IAS 32.16A and 16B for puttable instruments

Puttable instruments and obligations arising on liquidation

In February 2008, the IASB amended IAS 32 and IAS 1 Presentation of Financial Statements with respect to the balance sheet classification of puttable financial instruments and obligations arising only on liquidation. As a result of the amendments, some financial instruments that currently meet the definition of a financial liability will be classified as equity because they represent the residual interest in the net assets of the entity.

Classifications of rights issues

In October 2009, the IASB issued an amendment to IAS 32 on the classification of rights issues. For rights issues offered for a fixed amount of foreign currency current practice appears to require such issues to be accounted for as derivative liabilities. The amendment states that if such rights are issued pro rata to an entity’s all existing shareholders in the same class for a fixed amount of currency, they should be classified as equity regardless of the currency in which the exercise price is denominated.

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.

Interest, dividends, gains, and losses relating to an instrument classified as a liability should be reported in profit or loss. This means that dividend payments on preferred shares classified as liabilities are treated as expenses. On the other hand, distributions (such as dividends) to holders of a financial instrument classified as equity should be charged directly against equity, not against earnings.

Transaction costs of an equity transaction are deducted from equity. Transaction costs related to an issue of a compound financial instrument are allocated to the liability and equity components in proportion to the allocation of proceeds.

Interest, dividends, losses and gains

Interest, dividends, losses and gains arising in relation to a financial instrument that is classified as a financial liability should be recognised in profit or loss for the relevant period.

The costs of servicing the financing of a company must be treated consistently with the way that the underlying instrument has been treated:

• Dividends on ordinary shares and irredeemable preference shares where the payment of dividends is discretionary will be shown as an appropriation of profit (in the statement of changes in equity), net of any tax benefit.
• The cost of servicing loans will be shown as interest payable as a finance cost (in profit or loss).
• Dividends on redeemable preference shares and irredeemable preference shares where the payment of dividends is mandatory will be shown alongside interest payable as part of the finance cost (in profit or loss).

Distributions, such as dividends, paid to holders of a financial instrument classified as equity should be charged directly against equity (as part of the movement on retained earnings in the statement of changes in equity).

The classification will not affect the cash flows which are the same regardless of the presentation.

Treasury shares

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.

The treatment of these treasury shares is as follows:

• They should be deducted from equity (shown as a separate reserve) and the original share capital and share premium amounts remain unchanged
• No gain or loss should be recognised in profit or loss on their purchase, sale, issue or cancellation.
• Consideration paid or received should be recognised directly in equity.
• Although the shares are shown separately in equity, they are deducted in the weighted average number of shares calculation for the purposes of calculating EPS

The amount of treasury shares held should be disclosed either in the statement of financial position or in the notes to the financial statements in accordance with IAS 1, Presentation of Financial Statements

Offsetting

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.

It may be the case that one entity both owes money to and is due money from another entity. A frequently occurring example of this is where a company has several accounts with a single bank, some of which are in credit and some overdrawn. The presentation issue is whether these amounts should be shown separately or whether they should be netted off against each other and a single figure for the resulting net asset (or liability) shown.

IAS 32 looks to see whether there is a legally enforceable right to make the set off. But it then goes further, by taking account of the entity’s intentions. If there is a legal right to make a set off and the entity intends to settle the amounts on a net basis, then the set off must be made.

On this basis an entity with credit and overdrawn bank balances would not set them off against each other (even if it had the legal right to do so) because in the normal course of business it is keeping these accounts separate, so it cannot claim that it ‘intends’ to settle on a net basis

Disclosures

Financial instruments disclosures are in IFRS 7 Financial Instruments: Disclosures, and no longer in IAS 32.

The disclosures relating to treasury shares are in IAS 1 Presentation of Financial Statements and IAS 24 Related Parties for share repurchases from related parties.

Further Information