Presentation of financial instruments
This briefing document summarizes the main themes and important ideas and facts from the provided sources related to IAS 32 Financial Instruments: Presentation. The core focus of IAS 32 is on how to classify financial instruments as either financial liabilities or equity instruments in the financial statements.
1. Core Principle: Substance Over Form and Contractual Obligations
The overarching principle of IAS 32 is that the classification of a financial instrument is based on the substance of the contractual arrangement and the definitions of a financial liability, a financial asset, and an equity instrument, rather than its legal form.
- “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.”
- “Classify financial instruments as financial liabilities or equity by considering only contractual rights and obligations enforceable by law or regulation (that are in addition to those established by relevant laws or regulations).”
2. Defining Financial Liabilities
A key theme is the definition of a financial liability. A financial liability arises when an entity has a contractual obligation:
- To deliver cash or another financial asset to another entity.
- To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity.
Several specific types of instruments are highlighted as typically meeting the definition of a financial liability:
- Puttable Instruments: A financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset is a financial liability. This classification holds regardless of when the right is exercisable, how the amount payable is determined (even if based on an index), or whether it has a fixed maturity.
- “The Board decided that a financial instrument that gives the holder the right to put the instrument back to the entity for cash or another financial asset is a financial liability of the entity.” (IAS 32 BC, BC7)
- “…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…”
- “IAS 32 incorporates a guidance that a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset (a ‘puttable instrument’) is a financial liability of the issuer.”
- Obligation to Purchase Own Shares: When an issuer has a contractual obligation to purchase its own shares for cash or another financial asset, a financial liability exists for the amount the issuer is obliged to pay. This includes written put options on the entity’s own equity.
- “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.”
- “An entity’s contractual obligation to purchase its own equity instruments gives rise to a financial liability for the present value of the redemption amount even if the obligation to purchase is conditional on the counterparty exercising a right to redeem (e.g. a written put option that gives the counterparty the right to sell an entity’s own equity instruments to the entity for a fixed price).”
- Contracts Settled by Delivering a Variable Number of Own Shares for a Fixed Amount: Contracts that will be settled by the entity delivering or receiving a fixed number of its own equity instruments in exchange for a variable amount of cash or another financial asset are financial assets or financial liabilities.
- “In particular, when an entity 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 (e.g. a commodity price), the contract is not an equity instrument, but is a financial asset or a financial liability.”
- “A contract that will be settled by the entity 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.”
3. Defining Equity Instruments
An equity instrument is defined as a contract that evidences a residual interest in the assets of the entity after deducting all of its liabilities. Key characteristics include:
- No contractual obligation to deliver cash or another financial asset.
- Settlement in the entity’s own equity instruments where the number of equity instruments to be received or delivered is fixed in exchange for a fixed amount of cash or another financial asset.
4. Rights Issues
Rights issues, which grant existing shareholders the right to acquire a fixed number of additional shares pro rata at a typically below-market exercise price, are generally considered equity instruments.
- “These rights are commonly described as ‘rights issues’ and include rights, options and warrants. Laws or regulations in many jurisdictions throughout the world require the use of rights issues when raising capital. The entity issues one or more rights to acquire a fixed number of additional shares pro rata to all existing shareholders of a class of non-derivative equity instruments. The exercise price is normally below the current market price of the shares. Consequently, a shareholder must exercise its rights if it does not wish its proportionate interest in the entity to be diluted.”
5. Entities with Share Capital Not Meeting the Definition of Equity
The standard addresses entities like mutual funds and cooperatives that issue instruments redeemable at the holder’s option for a proportionate share of the net assets. Despite their legal form often including a right to the residual interest, the put option makes these instruments financial liabilities.
- “Such financial instruments are commonly issued by mutual funds, unit trusts, co-operative and similar entities, often with the redemption amount being equal to a proportionate share in the net assets of the entity. Although the legal form of such financial instruments often includes a right to the residual interest in the assets of an entity available to holders of such instruments, the inclusion of an option for the holder to put the instrument back to the entity for cash or another financial asset means that the instrument meets the definition of a financial liability.”
- “For example, open-ended mutual funds, unit trusts, partnerships and some co-operative entities 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…”
6. Shareholder Discretion vs. Company Obligation
The classification considers legally enforceable contractual obligations. The mere discretion of the issuer’s shareholders to approve a settlement involving cash does not necessarily negate the classification as a financial liability if the underlying obligation exists at the company level. A factors-based approach may be used to assess such situations.
- “IAS 32: if no unconditional right to avoid delivering cash (or another financial asset) to settle a contractual obligation, the obligation meets the definition of a financial liability.”
- “When settlement of contractual obligation is at discretion of issuer’s shareholders, is a decision of shareholders treated as a decision of the company?”
- “Proposal: a factors-based approach to help companies apply judgement”
7. Interactions with Other Standards
IAS 32 is referenced by and interacts with several other IFRS standards, including:
- IFRS 2 Share-based Payment: Discusses the accounting for rights issues with certain characteristics.
- IAS 33 Earnings per Share: Also discusses rights issues.
- IFRS 9 Financial Instruments: Relevant for the accounting of financial assets and liabilities. Amendments to IAS 32 have been made due to the issuance of IFRS 9.
- IFRS 17 Insurance Contracts: Has led to amendments in the treasury share requirements within IAS 32.
- IFRIC 2 Members’ Shares in Co-operative Entities and Similar Instruments: Provides guidance on the classification of such instruments, consistent with the principles of IAS 32 regarding puttable instruments.
8. Scope and Definitions
- IAS 32 defines a financial instrument as any contract that gives rise to both a financial asset for one entity and a financial liability or equity instrument for another entity.
- It provides detailed definitions of financial assets, financial liabilities, and equity instruments.
- The standard also clarifies the scope regarding contracts to buy or sell non-financial items that can be net settled in cash or other financial instruments, treating them as financial instruments unless they were entered into and continue to be held for the purpose of the receipt or delivery of the non-financial item according to the entity’s expected usage requirements.
- “IAS 32 defines a financial instrument as any contract that gives rise to both a financial asset for one entity and a financial liability or equity instrument for another entity.”
- “This Standard shall be applied to those contracts to buy or sell a non-financial item 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 in accordance with the entity’s expected…”
9. Illustrative Examples and Basis for Conclusions
The sources include illustrative examples to demonstrate the application of IAS 32 in various scenarios (e.g., accounting for forwards, options, and entities like mutual funds). The Basis for Conclusions provides further explanation of the Board’s reasoning behind the requirements in IAS 32.
10. Amendments and Interpretations
IAS 32 has been amended over time, particularly in relation to puttable instruments and rights issues. Several IFRIC Interpretations (e.g., IFRIC 2, IFRIC 11, IFRIC 12) provide further guidance on specific aspects related to financial instruments and their presentation.
This briefing highlights the central role of contractual obligations and the substance of the arrangement in classifying financial instruments under IAS 32. The treatment of puttable instruments as liabilities and the specific considerations for rights issues and entities with unique capital structures are important aspects of the standard. Understanding the interplay with other IFRS standards is also crucial for proper application.