Workbook on IAS 32 Financial Instruments Presentation

Principle

When an issuer determines whether a financial instrument is a financial liability, or an equity instrument, the instrument is an equity instrument only if both conditions (1) and (2) are met.

(1) The instrument includes no contractual obligation:

(i) to deliver cash, or another financial asset, to another undertaking; or

(ii) to exchange financial assets, or financial liabilities, with another undertaking under conditions that are potentially unfavourable (will make a loss) to the issuer.

(2) 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 by the issuer exchanging a fixed amount of cash, or another financial asset, for a fixed number of its own equity instruments. (‘FIXED for FIXED’) For this purpose, the issuer's own equity instruments do not include instruments that are themselves contracts for the future receipt, or delivery, of the issuer's own equity instruments.

In addition, when an issuer has an obligation to purchase its own shares for cash, or another financial asset, there is a liability for the amount that the issuer is obliged to pay.

Classification of contracts settled in an undertaking's own equity instruments

The classification of derivative and non-derivative contracts indexed to, or settled in, an undertaking's own equity instruments has been clarified consistently with the principle above.

In particular, when an undertaking uses its own equity instruments 'as currency' in a contract to receive, or deliver, a variable number of shares whose value equals a fixed amount, or an amount based on changes in an underlying variable (eg a commodity price), the contract is not an equity instrument, but is a financial asset, or a financial liability.

Puttable instruments

A financial instrument that gives the holder the right to put (sell) the instrument back to the issuer for cash, or another financial asset, (a 'puttable instrument') is a financial liability of the issuer.

Contingent settlement provisions

A financial instrument is a financial liability when the manner of settlement depends on the occurrence, or non-occurrence, of uncertain future events, or on the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder.

(Contingent settlement provisions are ignored, when they apply only in the event of liquidation of the issuer, or are not genuine.)

Settlement options

Under IAS 32, a derivative financial instrument is a financial asset, or a financial liability when it gives one of the parties to it a choice of how it is settled, unless all of the settlement alternatives would result in it being an equity instrument.

Measurement of the components of a compound financial instrument on initial recognition

Any asset and liability components are separated first, and the residual is the amount of any equity component.

Treasury shares

The acquisition, or subsequent resale, by an undertaking of its own equity instruments does not result in a gain, or loss for the undertaking. It represents a transfer between those holders of equity instruments who have given up their equity interest, and those who continue to hold an equity instrument.

Interest, dividends, losses and gains

Transaction costs incurred as a necessary part of completing an equity transaction are accounted for as part of that transaction, and are deducted from equity.

IASB amended IAS 32 by requiring a limited number of financial instruments that meet the definition of a financial liability to be classified as equity.

The amendment addresses the classification of some:

(1) puttable financial instruments, and

(2) instruments, or components of instruments, that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation.

The objective was to improve the financial reporting of particular types of financial instruments that meet the definition of a financial liability, but represent the residual interest in the net assets of the undertaking.

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.

It applies to the classification of financial instruments, from the perspective of the issuer, into financial assets, financial liabilities and equity instruments; the classification of related interest, dividends, losses and gains; and the circumstances in which financial assets and financial liabilities should be offset.

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.

Scope

IAS 32 shall be applied by all undertakings to all types of financial instruments except :

(1) those interests in subsidiaries, associates or joint ventures.

(In some cases, an undertaking can account for these interests using IFRS 9; in those cases, undertakings shall apply the requirements of IAS 32. Undertakings shall also apply IAS 32 to all derivatives linked to interests in subsidiaries, associates or joint ventures.)

(2) employers' rights and obligations under employee benefit plans, to which IAS 19 applies.

(3) insurance contracts as defined in IFRS 4. However, IAS 32 applies to derivatives that are embedded in insurance contracts, if IFRS 9 requires the undertaking to account for them separately. Moreover, an issuer shall apply IAS 32 to financial guarantee contracts, if the issuer applies IFRS 9 in recognising and measuring the contracts, but shall apply IFRS 4 if the issuer elects.

(4) financial instruments that are within the scope of IFRS 4, as they contain a discretionary participation feature.

The issuer of these instruments is exempt from applying to these features paragraphs regarding the distinction between financial liabilities and equity instruments. However, these instruments are subject to all other requirements of IAS 32. Furthermore, IAS 32 applies to derivatives that are embedded in these instruments (see IFRS 9).

IAS 32 shall be applied to those contracts to buy, or sell, a non-financial item (such as a commodity) that can be settled net in cash, or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments,

with the exception of contracts that were entered into, and continue to be held, for the purpose of the receipt, or delivery, of a non-financial item (such as property, or a commodity), in accordance with the undertaking's expected purchase, sale, or usage requirements (delivery is expected).

There are various ways in which a contract to buy, or sell, a non-financial item (such as property) can be settled net in cash, or another financial instrument, or by exchanging financial instruments. These include:

1. when the terms of the contract permit either party to settle it net in cash, or another financial instrument, or by exchanging financial instruments;

(2) when the ability to settle net in cash, or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the undertaking has a practice of settling similar contracts net in cash, or another financial instrument, or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts, or by selling the contract before its exercise, or lapse);

(3) when, for similar contracts, the undertaking has a practice of taking delivery of the underlying, and selling it within a short period after delivery, for the purpose of generating a profit from short-term fluctuations in price or dealer's margin; and

(4) when the non-financial item (such as a commodity) that is the subject of the contract is readily convertible to cash.

A contract to which (2) or (3) applies is not entered into for the purpose of the receipt, or delivery, of the non-financial item in accordance with the undertaking's expected purchase, sale or usage requirements, and, accordingly, is within the scope of IAS 32.

Other contracts are evaluated to determine whether they were entered into, and continue to be held, for the purpose of the receipt, or delivery, of the non-financial item, in accordance with the undertaking's expected purchase, sale or usage requirement, and accordingly, whether they are within the scope of IAS 32.

A written option to buy, or sell, a non-financial item (such as a commodity) that can be settled net in cash, or another financial instrument, or by exchanging financial instruments, is within the scope of IAS 32. Such a contract cannot be entered into for the purpose of the receipt, or delivery, of the non-financial item in accordance with the undertaking's expected purchase, sale or usage requirements. (The contract holder will sell it before physical delivery takes place.)

Definitions

The following terms are used in IAS 32 with the meanings specified:

A financial instrument is any contract that gives rise to a financial asset of one undertaking and a financial liability, or equity instrument, of another undertaking.

A financial asset is any asset that is:

(1) cash;

(2) an equity instrument of another undertaking;

(3) a contractual right:

(i) to receive cash, or another financial asset, from another undertaking; or

(ii) to exchange financial assets, or financial liabilities, with another undertaking under conditions that are potentially favourable (profitable) to the undertaking; or

(4) a contract that will, or may, be settled in the undertaking's own equity instruments and is:

(i) a non-derivative for which the undertaking is, or may be, obliged to receive a variable number of the undertaking'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 undertaking's own equity instruments.

For this purpose, the undertaking's own equity instruments do not include puttable financial instruments classified as equity instruments,

-that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation, and

-are classified as equity instruments, or instruments that are contracts for the future receipt, or delivery, of the undertaking's own equity instruments.

A financial liability is any liability that is:

(1) a contractual obligation:

(i) to deliver cash, or another financial asset, to another undertaking; or

(ii) to exchange financial assets, or financial liabilities, with another undertaking under conditions that are potentially unfavourable (unprofitable) to the undertaking; or

(2) a contract that will, or may, be settled in the undertaking's own equity instruments and is:

(i) a non-derivative for which the undertaking is or may be obliged to deliver a variable number of the undertaking'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 undertaking's own equity instruments.

For this purpose, rights, options or warrants to acquire a fixed number of the undertaking's own equity instruments for a fixed amount of any currency are equity instruments, if the undertaking 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 undertaking's own equity instruments do not include puttable financial instruments that are classified as equity instruments, instruments that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation and are classified as equity instruments, or instruments that are themselves contracts for the future receipt, or delivery, of the undertaking's own equity instruments.

An equity instrument is any contract that evidences a residual interest in the assets of an undertaking, after deducting all of its liabilities.

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 (IFRS 13).

A puttable instrument is a financial instrument that gives the holder the right to put (sell) 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.

The following terms are defined in IFRS 9, or IAS 39 and are used in IAS 32 with the meaning specified in IAS 39 and IFRS 9.

amortised cost of a financial asset, or financial liability

derecognition

effective interest method

financial guarantee contract

financial liability at fair value through profit or loss

firm commitment

forecast transaction

hedge effectiveness

hedged item

hedging instrument

held for trading

regular way purchase or sale

transaction costs.

In IAS 32, '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.

In IAS 32, 'undertaking' includes individuals, partnerships, incorporated bodies, trusts and government agencies.

Presentation

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.

This classification issue can be important to financial institutions (and others):

Issuing a liability reduces capital. Issuing equity increases capital.

Many financial institutions have a regulatory requirement to hold a minimum capital. If specific financial instruments are classified as capital, they contribute to this requirement. As liabilities, they reduce capital.

A financial instrument is an equity instrument rather than a financial liability, the instrument is an equity instrument only if both conditions (1) and (2) below are met.

(1) The instrument includes no contractual obligation:

(i) to deliver cash, or another financial asset, to another undertaking; or

(ii) to exchange financial assets, or financial liabilities, with another undertaking under conditions that are potentially unfavourable (unprofitable) to the issuer.

(2) 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.

For this purpose, rights, options or warrants to acquire a fixed number of the undertaking's own equity instruments for a fixed amount of any currency are equity instruments, if the undertaking 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 issuer's own equity instruments do not include puttable instruments that have all the features and meet the conditions described below, or instruments that are contracts for the future receipt, or delivery, of the issuer's own equity instruments.

Puttable instruments

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 (sale). As a very limited 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:

1.It entitles the holder to a pro rata share of the undertaking's net assets in the event of the undertaking's liquidation. The undertaking's net assets are those assets that remain, after deducting all other claims on its assets.

A pro rata share is determined by:

(i) dividing the undertaking's net assets on liquidation into units of equal amount; and

(ii) multiplying that amount by the number of the units held by the financial instrument holder.

(2) 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:

(i) has no priority over other claims to the assets of the undertaking on liquidation, and

(ii) 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.

(3) 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.

(4) 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 undertaking, or to exchange financial assets, or financial liabilities with another undertaking, under conditions that are potentially unfavourable (unprofitable) to the undertaking, and it is not a contract that will, or may, be settled in the undertaking's own equity instruments.

(5) 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 undertaking over the life of the instrument (excluding any effects of the instrument).

For an instrument to be classified as an equity instrument, in addition to the instrument having all the above features, the issuer must have no other financial instrument, or contract, that has:

(1) 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 undertaking (excluding any effects of such instrument, or contract) and

(2) the effect of substantially restricting, or fixing, the residual return to the puttable instrument holders.

The undertaking shall not consider non-financial contracts with a holder of an instrument that have contractual terms and conditions that are similar to the contractual terms and conditions of an equivalent contract that might occur between a non-instrument holder and the issuing undertaking. (No similar contract exists with a third party.)

If the undertaking cannot determine that this condition is met, it shall not classify the puttable instrument as an equity instrument.

Instruments, or components of instruments, that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation

Some financial instruments include a contractual obligation for the issuing undertaking to deliver to another undertaking a pro rata share of its net assets only on liquidation.

The obligation arises because liquidation either is certain to occur and outside the control of the undertaking (for example, a limited-life undertaking), or is uncertain to occur, but is at the option of the instrument holder. 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:

(1) It entitles the holder to a pro rata share of the undertaking's net assets in the event of the undertaking's liquidation. The undertaking's net assets are those assets that remain after deducting all other claims on its assets. A pro rata share is determined by:

(i) dividing the net assets of the undertaking on liquidation into units of equal amount; and

(ii) multiplying that amount by the number of the units held by the financial instrument holder.

(2) 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:

(i) has no priority over other claims to the assets of the undertaking on liquidation, and

(ii) 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.

(3) All financial instruments in the class of instruments that is subordinate to all other classes of instruments must have an identical contractual obligation for the issuing undertaking to deliver a pro rata share of its net assets on liquidation.

For an instrument to be classified as an equity instrument, in addition to the instrument having all the above features, the issuer must have no other financial instrument or contract that has:

(1) 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 undertaking (excluding any effects of such instrument or contract) and

(2) the effect of substantially restricting, or fixing, the residual return to the instrument holders.

For the purposes of applying this condition, the undertaking shall not consider non-financial contracts with a holder of an instrument that have contractual terms and conditions that are similar to those of an equivalent contract that might occur between a non-instrument holder and the issuing undertaking. (No similar contract exists with a third party.) If the undertaking cannot determine that this condition is met, it shall not classify the instrument as an equity instrument.

Reclassification of puttable instruments and instruments that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation

An undertaking shall classify a financial instrument as an equity instrument from the date when the instrument has all the features and meets the conditions. An undertaking shall reclassify a financial instrument from the date when the instrument ceases to have all the features, or meet all the conditions.

EXAMPLE: RECLASSIFICATION

If an undertaking redeems all its issued non-puttable instruments, and any puttable instruments that remain outstanding have all the features, the undertaking shall reclassify the puttable instruments as equity instruments from the date when it redeems the non-puttable instruments.

An undertaking shall account as follows for the reclassification of an instrument:

(1) It shall reclassify an equity instrument as a financial liability from the date when the instrument ceases to have all the features or meet the conditions. The financial liability shall be measured at the instrument's fair value at the date of reclassification. The undertaking shall record in equity any difference between the carrying value of the equity instrument and the fair value of the financial liability, at the date of reclassification.

(2) It shall reclassify a financial liability as equity from the date when the instrument has all the features and meets the conditions. An equity instrument shall be measured at the carrying value of the financial liability at the date of reclassification.

No contractual obligation to deliver cash, or another financial asset

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 that are potentially unfavourable (unprofitable) to the issuer.

Although the holder of an equity instrument may be entitled to receive a pro rata share of any dividends, or other distributions of equity, the issuer does not have a contractual obligation to make such distributions, as it cannot be required to deliver cash, or another financial asset, to another party.

The substance of a financial instrument, rather than its legal form, governs its classification in the undertaking's statement of financial position.

Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity, but are liabilities in substance, and others may combine features associated with equity instruments and features associated with financial liabilities.

EXAMPLES: INSTRUMENTS WITH FEATURES OF LIABILITIES

(1) a preference share that provides for mandatory redemption by the issuer for a fixed, or determinable amount, at a fixed, or determinable, future date, or gives the holder the right to require the issuer to redeem the instrument at, or after, a particular date for a fixed, or determinable amount, is a financial liability .

(2) a financial instrument that gives the holder the right to put it back to the issuer for cash, or another financial asset (a 'puttable instrument') is a financial liability, except for those puttable instruments classified as equity instruments (see above).

The financial instrument is a financial liability even when the amount of cash, or other financial assets, is determined on the basis of an index, or other item, that has the potential to increase.

The existence of an option for the holder to put the instrument back to the issuer for cash, or another financial asset means that the puttable instrument meets the definition of a financial liability, except for puttable those instruments classified as equity instruments.

For example, open-ended mutual funds, unit trusts, partnerships and some co-operative undertakings may provide their unitholders or members with a right to redeem their interests in the issuer at any time for cash, which results in the unitholders' or members' interests being classified as financial liabilities, except for those puttable instruments classified as equity instruments.

However, classification as a financial liability does not preclude the use of descriptors such as 'net asset value attributable to unitholders' and 'change in net asset value attributable to unitholders' in the financial statements of an undertaking that has no contributed equity (such as some mutual funds and unit trusts), or the use of additional disclosure to show that total members' interests comprise items such as reserves that meet the definition of equity, and puttable instruments that do not.

If an undertaking does not have an unconditional right to avoid delivering cash, or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability, except for those puttable instruments classified as equity instruments.

EXAMPLES: CONTRACTUAL OBLIGATIONS

(1) a restriction on the ability of an undertaking to satisfy a contractual obligation, such as lack of access to foreign currency, or the need to obtain approval for payment from a regulatory authority, does not negate the undertaking's contractual obligation, or the holder's contractual right, under the instrument.

(2) a contractual obligation that is conditional on a counterparty exercising its right to redeem is a financial liability, as the undertaking does not have the unconditional right to avoid delivering cash, or another financial asset.

A financial instrument that does not explicitly establish a contractual obligation to deliver cash, or another financial asset may establish an obligation indirectly through its terms and conditions.

EXAMPLES: OBLIGATIONS IN TERMS AND CONDITIONS

(1) a financial instrument may contain a non-financial obligation that must be settled only if the undertaking fails to make distributions, or to redeem the instrument. If the undertaking can avoid a transfer of cash, or another financial asset, only by settling the non-financial obligation, the financial instrument is a financial liability.

(2) a financial instrument is a financial liability if it provides that, on settlement, the undertaking will deliver either:

(i) cash, or another financial asset; or

(ii) its own shares whose value is determined to exceed substantially the value of the cash, or other financial asset.

Although the undertaking does not have an explicit contractual obligation to deliver cash, or another financial asset, the value of the share settlement alternative is such that the undertaking will settle in cash. In any event, the holder has, in substance, been guaranteed receipt of an amount that is at least equal to the cash settlement option.

Settlement in the undertaking's own equity instruments

A contract is not an equity instrument solely because it may result in the receipt, or delivery, of the undertaking's own equity instruments.

An undertaking may have a contractual right, or obligation, to receive, or deliver, a number of its own shares, or other equity instruments, that varies so that the fair value of the undertaking's own equity instruments to be received, or delivered, equals the amount of the contractual right, or obligation.

Such a contractual right, or obligation, may be for a fixed amount, or an amount that fluctuates in part, or in full, in response to changes in a variable other than the market price of the undertaking's own equity instruments (such as an interest rate, a commodity price or a financial instrument price).

EXAMPLES: CONTRACTS FOR SHARES TO PAY FIXED LIABILITIES

(1) a contract to deliver as many of the undertaking's own equity instruments as are equal in value to $100,000, and

(2) a contract to deliver as many of the undertaking's own equity instruments as are equal in value to the value of 100 ounces of gold.

Such a contracts are financial liabilities, even though the undertaking must, or can, settle it by delivering its own equity instruments.

It is not an equity instrument because the undertaking uses a variable number of its own equity instruments as a means to settle the contract.

The contract does not evidence a residual interest in the undertaking's assets after deducting all of its liabilities.

Except for qualifying puttable instruments, a contract that will be settled by the undertaking receiving, or delivering, a fixed number of its own equity instruments in exchange for a fixed amount of cash, or another financial asset is an equity instrument.

EXAMPLE: SHARE OPTION = EQUITY INSTRUMENT

An issued share option that gives the counterparty a right to buy a fixed number of the undertaking's shares for a fixed price, or for a fixed stated principal amount of a bond, is an equity instrument.

Changes in the fair value of a contract, arising from variations in market interest rates that do not affect the amount of cash, or other financial assets, to be paid (or received), or the number of equity instruments to be received or delivered, on settlement of the contract do not preclude the contract from being an equity instrument.

Any consideration received (such as the premium received for a written option, or warrant on the undertaking's own shares) is added directly to equity.

Any consideration paid (such as the premium paid for a purchased option) is deducted directly from equity.

Changes in the fair value of an equity instrument are not recognised in the financial statements.

If the undertaking's own equity instruments to be received, or delivered, by the undertaking upon settlement of a contract are puttable financial instruments with all the features and meeting the conditions, or instruments that impose on the undertaking an obligation to deliver to another party a pro rata share of the net assets of the undertaking only on liquidation with all the features and meeting the conditions, the contract is a financial asset, or a financial liability.

This includes a contract that will be settled by the undertaking receiving, or delivering, a fixed number of such instruments in exchange for a fixed amount of cash, or another financial asset.

With the exception of qualifying puttable instruments, a contract that contains an obligation for an undertaking to purchase its own equity instruments for cash, or another financial asset, gives rise to a financial liability for the present value of the redemption amount (for example, for the present value of the forward repurchase price, option exercise price or other redemption amount).

This is the case even if the contract itself is an equity instrument.

EXAMPLE: CONTRACT TO BUY ITS OWN SHARES

An undertaking's obligation under a forward contract to buy its own equity instruments for cash: when the financial liability is recognised initially under IFRS 9, its fair value (the present value of the redemption amount) is reclassified from equity to liabilities.

Subsequently, the financial liability is measured in accordance with IFRS 9.

If the contract expires without delivery, the carrying amount of the financial liability is reclassified to equity.

An undertaking's contractual obligation to buy its own equity instruments gives rise to a financial liability for the present value of the redemption amount, even if the obligation to buy is conditional on the counterparty exercising a right to redeem (such as a written put option, that gives the counterparty the right to sell an undertaking's own equity instruments to the undertaking, for a fixed price).

A contract that will be settled by the undertaking delivering, or receiving, a fixed number of its own equity instruments in exchange for a variable amount of cash, or another financial asset is a financial asset, or financial liability.

EXAMPLE: FIXED NUMBER OF SHARES FOR VARIABLE AMOUNT OF CASH

A contract for the undertaking to deliver 100 of its own equity instruments in return for an amount of cash, calculated to equal the value of 100 ounces of gold.

Contingent settlement provisions

A financial instrument may require the undertaking to deliver cash, or another financial asset, or otherwise to settle it in such a way that it would be a financial liability, in the event of the occurrence, or non-occurrence, of uncertain future events (or on the outcome of uncertain circumstances) that are beyond the control of both the issuer and the holder of the instrument, such as a change in a stock market index, consumer price index, interest rate or taxation requirements, or the issuer's future revenues, net income or debt-to-equity ratio.

The issuer of such an instrument does not have the unconditional right to avoid delivering cash, or another financial asset (or otherwise to settle it in such a way that it would be a financial liability).

Therefore, it is a financial liability of the issuer unless:

(1) the part of the contingent settlement provision that could require settlement in cash, or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine; or

(2) the issuer can be required to settle the obligation in cash, or another financial asset (or otherwise to settle it in such a way that it would be a financial liability) only in the event of liquidation of the issuer; or

(3) it is a qualifying puttable instrument that has all the features and meets the conditions.

Settlement options

When a derivative financial instrument gives one party a choice over how it is settled (for example, the issuer or the holder can choose settlement net in cash, or by exchanging shares for cash), it is a financial asset, or a financial liability, unless all of the settlement alternatives would result in it being an equity instrument.

EXAMPLE: DERIVATIVE WITH SETTLEMENT OPTION THAT IS A LIABILITY

A share option that the issuer can decide to settle net in cash, or by exchanging its own shares for cash.

Similarly, some contracts to buy, or sell, a non-financial item in exchange for the undertaking's own equity instruments are within the scope of IAS 32, as they can be settled either by delivery of the non-financial item, or net in cash, or another financial instrument. Such contracts are financial assets, or financial liabilities and not equity instruments.

Compound financial instruments

The issuer of a non-derivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets or equity.

EXAMPLES: COMPOUND FINANCIAL INSTRUMENTS 1
Convertible loans (convertible into ordinary shares), convertible preference shares (convertible into ordinary shares), loans with warrants (warrants convertible into ordinary shares).

The purpose of the conversion option, or warrant, is to lower the interest paid to the lenders. The lenders sacrifice some interest in return for the share option. They will be able to buy some shares in the future at a price set today. If the shares are above that price, they can exercise the option to buy them and sell them at a profit.

An additional benefit to the issuer of convertible loans is that they will not have to repay the loan principal if the options are exercised. If they are not exercised, they will have to repay the principal, but they will have paid a lower rate of interest.

An undertaking records separately the components of a financial instrument that

(1) creates a financial liability of the undertaking and

(2) grants an option to the holder of the instrument to convert it into an equity instrument of the undertaking.

EXAMPLES: COMPOUND FINANCIAL INSTRUMENTS 2

A bond, or similar instrument, convertible by the holder into a fixed number of ordinary shares of the undertaking is a compound financial instrument.

From the perspective of the undertaking, such an instrument comprises two components:

-a financial liability (a contractual arrangement to deliver cash, or another financial asset) and

-an equity instrument (a call- sell-option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the undertaking).

The economic effect of issuing such an instrument is substantially the same as issuing simultaneously

-a debt instrument with an early settlement provision and

-warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants.

Accordingly, in all cases, the undertaking presents the liability and equity components separately in its statement of financial position.

Classification of the liability and equity components of a convertible instrument is not revised as a result of a change in the likelihood that a conversion option will be exercised, even when exercise of the option may appear to have become profitable to some holders.

The likelihood of conversion will change from time to time. The undertaking's contractual obligation to make future payments remains outstanding until it is extinguished through conversion, maturity of the instrument, or some other transaction.

IFRS 9 deals with the measurement of financial assets and financial liabilities. Equity instruments are instruments that evidence a residual interest in the assets of an undertaking, after deducting all of its liabilities.

When the initial carrying amount of a compound financial instrument is 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 value of any derivative features (such as a call option) embedded in the compound financial instrument other than the equity component (such as an equity conversion option) is included in the liability component.

The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the fair value that would be ascribed to the instrument as a whole. No gain, or loss arises from initially recording the components of the instrument separately.

The issuer of a bond convertible into ordinary shares first determines the carrying amount of the liability component by measuring the fair value of a similar liability (including any embedded non-equity derivative features) that does not have an associated equity component.

The carrying amount of the equity instrument represented by the option to convert the instrument into ordinary shares is then determined by deducting the fair value of the financial liability from the fair value of the compound financial instrument as a whole.

Treasury shares

If an undertaking reacquires its own equity instruments, those instruments ('treasury shares') shall be deducted from equity. No gain, or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an undertaking's own equity instruments.

Such treasury shares may be acquired and held by the undertaking or by other members of the consolidated group. Consideration paid, or received, shall be recognised directly in equity.

The amount of treasury shares held is disclosed separately, either in the statement of financial position or in the notes, in accordance with IAS 1. An undertaking provides disclosure in accordance with IAS 24 Related Party Disclosures, if the undertaking reacquires its own equity instruments from related parties.

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 debited by the undertaking directly to equity, net of any related income tax benefit.

Transaction costs of an equity transaction shall be accounted for as a deduction from equity, net of any related income tax benefit.

The classification of a financial instrument as a financial liability, or an equity instrument, determines whether interest, dividends, losses and gains relating to that instrument are recognised as income or expense in profit or loss.

Thus, dividend payments on shares wholly recognised as liabilities (such as redeemable preference shares) are recorded as expenses, in the same way as interest on a bond.

Similarly, gains and losses associated with redemptions, or refinancings, of financial liabilities are recognised in profit or loss, whereas redemptions, or refinancings, of equity instruments are recognised as changes in equity.

Changes in the fair value of an equity instrument are not recognised in the financial statements.

An undertaking incurs various costs in issuing, or acquiring, its own equity instruments. Those costs might include registration and other regulatory fees, amounts paid to legal, accounting and other professional advisers, printing costs and stamp duties.

The transaction costs of an equity transaction are accounted for as a deduction from equity (net of any related income tax benefit). The costs of an equity transaction that is abandoned are recorded as an expense.

Transaction costs that relate to the issue of a compound financial instrument are allocated to the liability and equity components of the instrument, in proportion to the allocation of proceeds.

The amount of transaction costs accounted for as a deduction from equity in the period is disclosed separately under IAS 1. The related amount of income taxes recognised directly in equity is included in the aggregate amount of current and deferred income tax credited, or charged, to equity that is disclosed under IAS 12.

Dividends classified as an expense may be presented in the statement of comprehensive income either with interest on other liabilities, or as a separate item. In addition to the requirements of IAS 32, disclosure of interest and dividends is subject to the requirements of IAS 1 and IFRS 7.

In some circumstances, because of the differences between interest and dividends with respect to matters such as tax deductibility, it is desirable to disclose them separately in the statement of comprehensive income. Disclosures of the tax effects are made in accordance with IAS 12.

Gains and losses related to changes in the carrying amount of a financial liability are recognised as income, or expense, in profit or loss, even when they relate to an instrument that includes a right to the residual interest in the assets of the undertaking in exchange for cash, or another financial asset.

Under IAS 1, the undertaking presents any gain, or loss, arising from remeasurement of such an instrument separately in the statement of comprehensive income, when it is relevant in explaining the undertaking's performance.

Offsetting a financial asset and a financial liability

A financial asset and a financial liability shall be offset, and the net amount presented in the statement of financial position only when an undertaking:

(1) currently has a legally-enforceable right to set off the recognised amounts; and

(2) intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

In accounting for a transfer of a financial asset that does not qualify for derecognition, the undertaking shall not offset the transferred asset and the associated liability. Examples REPO’s and reverse REPO’s.

IAS 32 requires the presentation of financial assets and financial liabilities on a net basis, when doing so reflects an undertaking's expected future cash flows from settling two, or more, separate financial instruments.

When an undertaking has the right to receive, or pay, a single net amount and intends to do so, it has, in effect, only a single financial asset, or financial liability. In other circumstances, financial assets and financial liabilities are presented separately from each other consistently, with their characteristics as resources, or obligations, of the undertaking.

Offsetting a recognised financial asset and a recognised financial liability, and presenting the net amount differs from the derecognition of a financial asset, or a financial liability. Although offsetting does not give rise to recognition of a gain, or loss, the derecognition of a financial instrument may result in recognition of a gain, or loss.

A right of set-off is a debtor's legal right, by contract or otherwise, to settle or otherwise eliminate all, or a portion, of an amount due to a creditor, by applying against that amount, an amount due from the creditor.

In unusual circumstances, a debtor may have a legal right to apply an amount due from a third party against the amount due to a creditor, provided that there is an agreement between the three parties that clearly establishes the debtor's right of set-off. The laws applicable to the relationships between the parties need to be considered.

The existence of an enforceable right to set off a financial asset and a financial liability affects the rights and obligations associated with a financial asset and a financial liability and may affect an undertaking's exposure to credit and liquidity risk.

However, the existence of the right, by itself, is not a sufficient basis for offsetting. In the absence of an intention to exercise the right or to settle simultaneously, the amount and timing of an undertaking's future cash flows are not affected.

When an undertaking intends to exercise the right, or to settle simultaneously, presentation of the asset and liability on a net basis reflects more appropriately the amounts and timing of the expected future cash flows, as well as the risks to which those cash flows are exposed.

An intention by one, or both, parties to settle on a net basis, without the legal right to do so, is not sufficient to justify offsetting, as the rights and obligations associated with the individual financial asset and financial liability remain unaltered.

An undertaking's intentions with respect to settlement of particular assets and liabilities may be influenced by its normal business practices, the requirements of the financial markets and other circumstances that may limit the ability to settle net, or to settle simultaneously.

When an undertaking has a right of set-off, but does not intend to settle net, or to realise the asset and settle the liability simultaneously, the effect of the right on the undertaking's credit risk exposure is disclosed in accordance with IFRS 7.

Simultaneous settlement of two financial instruments may occur through, for example, the operation of a clearing house in an organised financial market, or a face-to-face exchange. In these circumstances, the cash flows are, in effect, equivalent to a single net amount, and there is no exposure to credit, or liquidity risk.

In other circumstances, an undertaking may settle two instruments by receiving, and paying, separate amounts, becoming exposed to credit risk for the full amount of the asset, or liquidity risk for the full amount of the liability.

Such risk exposures may be significant, even though brief. Accordingly, realisation of a financial asset and settlement of a financial liability are treated as simultaneous only when the transactions occur at the same moment.

The conditions are generally not satisfied, and offsetting is usually inappropriate when:

(1) several different financial instruments are used to emulate the features of a single financial instrument (a 'synthetic instrument');

(2) financial assets and financial liabilities arise from financial instruments having the same primary risk exposure (for example, assets and liabilities within a portfolio of forward contracts or other derivative instruments), but involve different counterparties;

(3) financial, or other, assets are pledged as collateral for non-recourse financial liabilities;

(4) financial assets are set aside in trust by a debtor, for the purpose of discharging an obligation without those assets having been accepted by the creditor in settlement of the obligation (for example, a sinking fund arrangement); or

(5) obligations incurred as a result of events giving rise to losses are expected to be recovered from a third party by virtue of a claim made under an insurance contract.

An undertaking that undertakes a number of financial instrument transactions with a single counterparty may enter into a 'master netting arrangement' with that counterparty. Such an agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default on, or termination of, any one contract.

These arrangements are commonly used by financial institutions to provide protection against loss in the event of bankruptcy, or other circumstances that result in a counterparty being unable to meet its obligations.

A master netting arrangement commonly creates a right of set-off that becomes enforceable and affects the realisation, or settlement, of individual financial assets and financial liabilities only following a specified event of default, or in other circumstances not expected to arise in the normal course of business.

A master netting arrangement does not provide a basis for offsetting unless both of the criteria above are satisfied. When financial assets and financial liabilities subject to a master netting arrangement are not offset, the effect of the arrangement on an undertaking's exposure to credit risk is disclosed in accordance with IFRS 7.

IFRIC Interpretation 19 Extinguishing Financial Liabilities with Equity Instruments

Background

A debtor and creditor might renegotiate the terms of a financial liability with the result that the debtor extinguishes the liability fully or partially by issuing equity instruments to the creditor. These transactions are sometimes referred to as ‘debt for equity swaps’.

Scope

This Interpretation addresses the accounting by an entity when the terms of a financial liability are renegotiated and result in the entity issuing equity instruments to a creditor of the entity to extinguish all or part of the financial liability. It does not address the accounting by the creditor.

An entity shall not apply this Interpretation to transactions in situations where:

(a) the creditor is also a direct or indirect shareholder and is acting in its capacity as a direct or indirect existing shareholder.

(b) the creditor and the entity are controlled by the same party or parties before and after the transaction and the substance of the transaction includes an equity distribution by, or contribution to, the entity.

(c) extinguishing the financial liability by issuing equity shares is in accordance with the original terms of the financial liability.

Issues

This Interpretation addresses the following issues:

(i) Are an entity’s equity instruments issued to extinguish all or part of a financial liability ‘consideration paid’ in accordance with paragraph 3.3.3 of IFRS 9?

(b) How should an entity initially measure the equity instruments issued to extinguish such a financial liability?

(c) How should an entity account for any difference between the carrying amount of the financial liability extinguished and the initial measurement amount of the equity instruments issued?

Consensus

The issue of an entity’s equity instruments to a creditor to extinguish all or part of a financial liability is consideration paid in accordance with paragraph 3.3.3 of IFRS 9. An entity shall remove a financial liability (or part of a financial liability) from its statement of financial position when, and only when, it is extinguished in accordance with paragraph 3.3.1 of IFRS 9.

When equity instruments issued to a creditor to extinguish all or part of a financial liability are recognised initially, an entity shall measure them at the fair value of the equity instruments issued, unless that fair value cannot be reliably measured.

If the fair value of the equity instruments issued cannot be reliably measured then the equity instruments shall be measured to reflect the fair value of the financial liability extinguished. In measuring the fair value of a financial liability extinguished that includes a demand feature (eg a demand deposit), paragraph 47 of IFRS 13 is not applied.

If only part of the financial liability is extinguished, the entity shall assess whether some of the consideration paid relates to a modification of the terms of the liability that remains outstanding.

If part of the consideration paid does relate to a modification of the terms of the remaining part of the liability, the entity shall allocate the consideration paid between the part of the liability extinguished and the part of the liability that remains outstanding. The entity shall consider all relevant facts and circumstances relating to the transaction in making this allocation.

The difference between the carrying amount of the financial liability (or part of a financial liability) extinguished, and the consideration paid, shall be recognised in profit or loss, in accordance with paragraph 3.3.3 of IFRS 9. The equity instruments issued shall be recognised initially and measured at the date the financial liability (or part of that liability) is extinguished.

When only part of the financial liability is extinguished, consideration shall be allocated in accordance with paragraph 8. The consideration allocated to the remaining liability shall form part of the assessment of whether the terms of that remaining liability have been substantially modified. If the remaining liability has been substantially modified, the entity shall account for the modification as the extinguishment of the original liability and the recognition of a new liability as required by paragraph 3.3.2 of IFRS 9.

An entity shall disclose a gain or loss recognised in accordance with paragraphs 9 and 10 as a separate line item in profit or loss or in the notes.

Examples

Examples of classification of contracts settled in an entity's own equity instruments (IAS 32)

IAS 32—Presentation Examples