Financial Instruments –Presentation: IAS 32

Wiecek and Young

IFRS PrimerChapter 19

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Financial Instruments – Presentation: IAS 32

Related standards IAS 32 Current GAAP comparisons Looking ahead End-of-chapter practice

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Related Standards

FAS 133 Accounting for Derivative Instruments and Hedging Activities FAS 138 Accounting for Certain Derivative Instruments and Certain Hedging

Activities—an amendment of FASB Statement No. 133 FAS 150 Accounting for Certain Financial Instruments with Characteristics of

both Liabilities and Equity FAS 155 Accounting for Certain Hybrid Financial Instruments—an

amendment of FASB Statements No. 133 FAS 157 Fair Value Measurements

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Related Standards

IFRS 7 Financial Instruments: Disclosures IAS 1 Presentation of Financial Statements IAS 39 Financial Instruments: Recognition and

Measurement

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IAS 32 – Overview

Objective and scope Presentation

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IAS 32 – Objective and Scope This standard deals with financial liabilities and equity instruments

from the perspective of the issuer

Provides guidance on how to present compound (hybrid) instruments, where the instrument contains both debt and equity components, including some guidance on how to measure and bifurcate compound instruments

Finally, it gives significant guidance on and examples of how to account for derivatives that deal with the entity’s own equity instruments

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IAS 32 – Objective and ScopeA 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 favorable 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 own equity instruments. For this purpose, the entity’s own equity instruments do not include puttable financial instruments classified as equity instruments . . . or instruments that are contracts for the future receipt or delivery of the entity’s own equity instruments

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IAS 32 – Objective and ScopeA 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 unfavorable 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, the entity’s own equity instruments do not include puttable financial instruments that are classified as equity instruments . . . or instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments

Recall that financial instruments represent contracts or arrangements between two parties where there are clear economic consequences for non-performance

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IAS 32 – Presentation An instrument is an equity instrument if it is residual in nature and both of the

following conditions are met:

(a) The instrument includes no 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 unfavorable to the issuer

(b) If the instrument will or may be settled in the issuer’s own equity instruments, it is

(i) A non-derivative that includes no contractual obligation for the issuer to deliver a variable number of its own equity instruments, or

(ii) 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

The most common example of an equity instrument is a common share

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IAS 32 – Presentation Puttable Instruments

Puttable instruments are defined as follows: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 instrument holder

If an instrument is puttable, it has an embedded put option and may be presented to the entity (issuer) for payment

In general, the put option represents an obligation on the part of the entity and is therefore presented as a financial liability

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IAS 32 – Presentation Puttable Instruments The standard allows an exception to the general treatment as a liability where the

following conditions are met:

(a) The instrument entitles the holder or another entity to a share of the entity’s net assets

upon liquidation

(b) The instrument is in a class of instruments that is subordinate to all other instruments

and is residual in nature (e.g., common shares)

(c) All instruments in the class have the same features including the put option

(d) The instrument otherwise does not meet the definition of a liability

(e) The expected cash flows of the instrument relate to the earnings of the entity

Thus, if the instruments are otherwise common shares except for the put option, they may be treated as equity

Finally, the entity may have no other instruments that would be subordinate to the puttable instruments

– The puttable instruments must represent the residual ownership interest

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IAS 32 – Presentation Puttable Instruments If originally classified as equity because they meet the criteria and then

cease to meet the criteria, they would be reclassified as liabilities

If reclassified, the instruments are valued as follows:

• From equity to liability, at fair value at the date of reclassification with the difference

being booked as equity

• From liability to equity, at the carrying value of the liability

No Contractual Obligation to Deliver Cash Following are examples of instruments that meet the definition of liabilities:

• Mandatorily redeemable shares

• Puttable instruments unless they meet certain criteria

Per IAS 32 the instrument is or contains a liability if the entity does not have the unconditional right to avoid delivering cash or other financial assets to settle the instrument

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IAS 32 – Presentation Settlement in the Entity’s Own Equity Instruments:

Non-derivativesFixed Versus Variable Number of Shares

Non-derivative contracts, such as debt, may include a contractual obligation to deliver shares when settled

Does this make the instrument an equity instrument? – As long as it is a fixed number of shares, the economic substance is that

the instrument is equity – The holder of the instrument will receive a fixed number of shares on

settlement (versus a variable number) and essentially has a residual interest in the entity

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IAS 32 – Presentation Fixed Versus Variable Number of Shares

If it can be settled in a variable number of shares then it is more like a liability

– The entity must give whatever number of shares is needed (depending on the market value of the shares) to settle the fixed value

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IAS 32 – PresentationSettlement in the Entity’s Own Equity Instruments: Derivatives

Net Settlement Provisions Derivatives settled in the entity’s own equity instrument are treated as derivatives and

accounted for as derivatives under IAS 39 if the contract includes a net settlement provision

If the contract is settled net in cash– The substance is that the entity is trading for profit using its own shares as the

underlying – This is more like an operating transaction than a capital transaction since the entity is

not buying or selling its own shares

Where the instruments may be settled net in shares, – The number of shares would vary with the settlement amount – Does not meet the definition of an equity instrument, which must be settled for a fixed

number of shares

In both cases above, the instruments are recognized in the financial statements, measured and remeasured at fair value, and gains/losses are booked to net income

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IAS 32 – PresentationGross Settlement Provisions Some contracts do not have net settlement provisions in them; they require that the

entity deliver or take delivery of the shares

Obligations to purchase own equity instruments: written put options or forwards– Where the entity is locked into purchasing a fixed amount of its own shares for cash, a

financial liability exists– The liability is measured at the present value of the redemption amount and credited

to a liability account– The corresponding debit is booked to equity since this is also an equity instrument

(under the contract, the entity will deliver a fixed amount of cash for a fixed number of shares)

Obligations to sell own equity instruments: written call options or forwards– When the entity agrees to sell its own shares, this is an equity instrument – If the contract is structured as an option, the entity writing the option receives a

premium upfront– The premium received on the issue is recorded as a credit to equity and debit to cash – If the contract is structured as a forward contract, there is no entry since no cash

changes hands and the fair value at inception is nil

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IAS 32 – PresentationGross Settlement Provisions Purchased options

– An entity may choose to purchase options on its own shares for a premium – Where these are settled gross (by delivery of shares if settled), they are equity

instruments and are recorded as a deduction from equity as opposed to an asset– The premium is therefore booked as a debit to equity and credit to cash

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IAS 32 – Presentation

Where the contract has a choice regarding settlement, it is treated as a derivative unless all options result in it meeting the definition of an equity instrument.

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IAS 32 – PresentationCompound Financial Instruments Contains both debt and equity components.

– For instance, convertible debt contains both a debt component plus an option to convert to common shares

If the entity holds an instrument as an investment, it is covered by IAS 39

If the entity is the issuer, the equity component is accounted for under IAS 32 as a residual interest in the entity, while the financial liability component is then covered by IAS 39

In terms of allocating an amount to the debt and equity components, the debt is measured first

– In general, the entity measures the liability at fair value– That is, the value of a similar instrument without the equity feature, which might

be approximated by doing a discounted cash flow calculation

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IAS 32 – Presentation

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IAS 32 – Presentation

• Once classified as debt or equity, a financial instrument is not subsequently changed as a result of a change in likelihood of conversion

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IAS 32 – PresentationContingent Settlement Provisions The entity may be required to deliver cash or other financial assets upon the

occurrence or non-occurrence of a future event, and that event is beyond the control of the entity (e.g., a change in the share price)

This would generally be treated as a financial liability

Settlement Options According to IAS 32.26, when the issuer or holder has a choice as to how to settle a

derivative (net or by exchanging shares for cash), it is a financial asset/liability unless all of the settlement options result in it being an equity instrument

Treasury Shares Treasury shares are shares acquired or reacquired by the entity

They are presented as a deduction from equity with no gains/losses recognized in profit and loss

These are capital transactions

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Current GAAP Comparisons

Pages 52, 86, & 142 of 164 ofhttp://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf

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Looking Ahead

Determining what is a liability versus equity is a very controversial topic which will have far reaching implications for many IFRS standards

As mentioned earlier, FASB and IASB are currently studying this issue and have a Discussion Paper out

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End-of-Chapter Practice

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End-of-Chapter Practice

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End-of-Chapter Practice

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