4.2.1 Relationship between an entity and its members

The unconditional right of the entity to avoid delivering cash or another financial asset in settlement of an obligation is crucial in differentiating a financial liability from an equity instrument. In our view, the role of the entity's shareholders is critical in determining the classification of financial instruments when the shareholders can decide whether the entity delivers cash or another financial asset. It is therefore important to understand the relationship between the entity and its members. Shareholders can make decisions as part of the corporate governance decision making process of the entity (generally exercised in a general meeting), or separate from the entity's corporate governance decision making process in their capacity as holders of particular instruments.

In some entities, the right to declare dividends and/or redeem capital is reserved for the members of the entity in general meeting, as a matter either of the entity's own constitution or of general legislation in the jurisdiction concerned. The effect of such a right may be that the members can require payment of a dividend irrespective of the wishes of management. Even where management has the right to prevent a payment declared by the members, the members will generally have the right to appoint the management, and can therefore appoint management that will not oppose an equity distribution declared by the members.

This raises the question whether an entity whose members have such rights should classify all its distributable retained earnings as a liability, on the grounds that the members could require earnings to be distributed as dividend, or capital to be repaid, at any time. In our view this is not appropriate, since an action reserved to the entity's shareholders in general meeting, is effectively an action of the entity itself. It is therefore at the discretion of the entity itself (as represented by the members in general meeting) that retained earnings are paid out as a dividend. Accordingly, in our view, such earnings are classified as equity, and not as a financial liability, until they become a legal liability of the entity.

If on the other hand, decisions by the shareholders are not made as part of the entity's corporate governance decision making process, but made in their capacity as holders of particular instruments, it is our view that the shareholders should be considered to be separate from the entity. The entity therefore would not have an unconditional right to avoid delivering cash or another financial asset and would have to classify the financial instrument as a financial liability.

This issue was brought to the Interpretations Committee in January 2010. The Interpretations Committee identified that diversity may exist in practice in assessing whether an entity has an unconditional right to avoid delivering cash if the contractual obligation is at the ultimate discretion of the issuer's shareholders, and consequently whether a financial instrument should be classified as a financial liability or equity. However, the Interpretations Committee concluded that the Board's then current project on financial instruments with characteristics of equity was expected to address the distinction between equity and non-equity instruments on a timely basis, and that the Interpretations Committee would therefore not add this to its agenda.⁵ In October 2010 the project was suspended but was restarted in October 2014 (see 12 below).

4.2.2 Implied contractual obligation to deliver cash or other financial assets

A financial instrument that does not explicitly establish a contractual obligation to deliver cash or another financial asset may nevertheless establish an obligation indirectly through its terms and conditions. [IAS 32.20].

IAS 32.20 provides two examples:

1. A financial instrument may contain a non-financial obligation that must be settled if, and only if, the entity fails to make distributions or to redeem the instrument. If the entity 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 entity will deliver either:
   1. cash or another financial asset; or
   2. its own shares whose value is determined to exceed substantially the value of cash or other financial asset.

Although the entity 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 entity will settle in cash. [IAS 32.20].

The basic requirement of IAS 32.20 is for an entity to recognise a financial liability when it can only avoid using cash to settle an obligation by transferring a financial asset or a non-financial asset, in other words settlement of the obligation cannot be avoided in any other way. Then, given that the entity's own shares are not an asset, subparagraph (b)(ii) avoids a potential loophole: if the value of the shares would exceed the amount of cash that would be required to settle the liability, the entity will be economically compelled to settle the cash amount and hence, has a financial liability.

This accounting treatment was illustrated by a question put to the Interpretations Committee in 2015.⁶ They considered an arrangement whereby an entity received cash from a government to fund a research and development project. The cash was repayable to the government only if the entity decided to exploit and commercialise the results of the project. If the project was not commercially exploited the entity was obliged to transfer the rights to the research to the government.

The Interpretations Committee observed in May 2016⁷ that, in this case, the cash receipt gave rise to a financial liability. In reaching their conclusion the Interpretations Committee took the view that the entity could avoid transferring cash only by settling the obligation with a non-financial instrument (the rights to the research). The Interpretations Committee further noted that the cash received from the government does not meet the definition of a forgivable loan in IAS 20 – Accounting for Government Grants and Disclosure of Government Assistance – as the government does not undertake to waive repayment of the loan but requires settlement in cash or by transfer of the rights to research. However they also noted that the entity would be required at initial recognition to assess whether the cash received from the government is something other than a financial instrument, for example the difference between the cash received and the fair value of the financial liability may represent a government grant that should be accounted for in accordance with IAS 20.

This last sentence implies that where the fair value of the alternative settlement option is less than fair value of the cash settlement option, paragraph 20 of IAS 32 only requires a financial liability to be recorded to the extent of the fair value of the alternative settlement option. But, in this example, the Interpretations Committee did not discuss what the fair value of the research and development might be. The Interpretations Committee's discussion demonstrates that where entities receive loans with alternative repayment conditions involving settlement with a non-financial asset, judgement will be necessary in assessing the substance of the settlement requirements and determining the value at inception of the non-financial asset.

4.3.1 Contingencies that are ‘not genuine’

A requirement to settle an instrument in cash or another financial asset (or otherwise in such a way that it would be a financial liability) is not genuine (see 4.3 above) if the requirement would arise ‘only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur’. [IAS 32.AG28].

Similarly, if the terms of an instrument provide for its settlement in a fixed number of the entity's equity instruments, but there are circumstances, beyond the entity's control, in which such settlement may be contractually precluded, and settlement in cash or other assets required instead, those circumstances can be ignored if there is ‘no genuine possibility’ that they will occur. In other words, the instrument continues to be regarded as an equity instrument and not as a financial liability. [IAS 32.AG28].

Guidance in IAS 32 on the meaning of ‘not genuine’ in this context is unfortunately restricted to the thesaurus of synonyms (‘extremely rare, highly abnormal and very unlikely to occur’) above. It is, however, helpful to consider the changes made when, in 2003, SIC‑5 – Classification of Financial Instruments – Contingent Settlement Provisions⁸ – was withdrawn, and its substance incorporated in these provisions of IAS 32. SIC‑5 had previously required redemption terms to be ignored if they were ‘remote’. Examples given by SIC‑5 were where the issue of shares is contingent merely on formal approval by the authorities, or where cash settlement is triggered by an index reaching an ‘extreme’ level relative to its level at the time of initial recognition of the instrument.⁹

IAS 32 deliberately did not reproduce the reference to, or the examples of, ‘remote’ events in SIC‑5. In the Basis for Conclusions to IAS 32 the IASB states that it does not believe it is appropriate to disregard events that are merely ‘remote’. [IAS 32.BC17]. Thus it is clear that, under the revised version of IAS 32, it is not appropriate to disregard a redemption term that is triggered only when an index reaches an extreme level. This suggests that it is not open to an entity to argue (for example) that a bond that is redeemed in cash only if the entity's share price falls below, or fails to reach, a certain level can be treated as an equity instrument on the grounds that there is no genuine possibility that the share price will perform in that way.

In general, terms are included in a contract for an economic purpose and therefore are genuine. The current reference in IAS 32 to terms that are ‘not genuine’ is presumably intended to deal with clauses inserted into the terms of financial instruments for some legal or tax reason (e.g. so as to make conversion technically ‘conditional’ rather than mandatory) but having no real economic purpose or consequence.

An example of a clause that has caused some debate on this point is a ‘regulatory change’ clause, generally found in the terms of capital instruments issued by financial institutions such as banks and insurance companies. Such entities are generally required by local regulators to maintain certain minimum levels of equity or highly subordinated debt (generally referred to as regulatory capital) in order to be allowed to do business.

A ‘regulatory change’ clause will typically require an instrument which, at the date of issue, is classified as regulatory capital to be repaid in the event that it ceases to be so classified. The practice so far of the regulators in many markets has been to make changes to a regulatory classification with prospective effect only, such that any instruments already in issue continue to be regarded as regulatory capital even though they would not be under the new rules.

This has led some to question whether a ‘regulatory change’ clause can be regarded as a contingent settlement provision which is ‘not genuine’.¹⁰ This is ultimately a matter for the judgement of entities and their auditors in the context of the relevant regulatory environment(s). This judgement has not been made easier by the greater unpredictability of the markets (and therefore of regulators' responses to it) since the last financial crisis.

4.3.2 Liabilities that arise only on liquidation

As noted in 4.3 above, IAS 32 provides that a contingent settlement provision that comes into play only on liquidation of the issuer may be ignored in determining whether or not a financial instrument is a financial liability. IAS 32 refers specifically to ‘liquidation’. In other words, if an instrument provides for redemption on the occurrence of events that are a possible precursor of liquidation (e.g. extreme insolvency, the financial statements not being prepared on a going concern basis, or the entity being placed under the protection of Chapter 11 of the United States Bankruptcy Code) but falling short of formal liquidation, the instrument must be treated as a financial liability. Also where liquidation is in the control of the holder, the instrument will be a liability as this exception only applies to contingencies beyond the control of both the issuer and the holder.

4.3.3 Liabilities that arise only on a change of control

A number of entities have issued instruments on terms that require the issuing entity to transfer cash or other financial assets only in the event of a change in control of the issuing entity. This raises the question of whether such an event is outside the control of the issuing entity, with the effect than any instrument containing such a provision would be classified as a liability to the extent of any obligations arising on a change of control.

This issue is far from straightforward. As noted at 4.2.1 above, it is our view that, where the power to make a decision is reserved for the members of an entity in general meeting, for the purposes of such a decision, the members and the entity are one and the same. Therefore, we consider that any change of control requiring the approval of the members in general meeting should be regarded as within the control of the entity.

Conversely, in our view, a change of control is not within the control of the entity where it can be effected by one or more individual shareholders without reference to the members in general meeting, for example where a shareholder holding 40% of the ordinary equity sells its shares to another party already owning 30%.

However, we recognise that such a distinction is not as clear-cut as might at first sight appear, and indeed in some situations may give rise to what could be regarded as a purely form-based distinction, as illustrated by Example 47.1 below.

In a situation such as that in Example 47.1 it would seem strange to say that a sale by private treaty is not within the control of X plc, but a sale agreed in general meeting is, when in either case all that matters is the intentions of A and B.

In our view, this is an area on which it would be useful for the IASB or the Interpretations Committee to issue guidance. It may be that such guidance would need to be based on ‘rules’ rather than principles.

4.3.4 Some typical contingent settlement provisions

The matrix below gives a number of contingent settlement provisions that we have encountered in practice – some common, some rather esoteric – together with our view as to whether they should be regarded as outside the control of the reporting entity. If a contingent settlement provision is regarded as outside the control of the issuing entity, the instrument will be classified as a liability by the issuer. If a contingent settlement provision is regarded as within the control of the reporting entity, the instrument will be classified as equity, provided that it has no other features requiring its classification as a liability and that the contingent settlement event is also outside the control of the holder.

4.4.1 Issued instruments

Under the criteria above, equity instruments under IAS 32 will include non-puttable common (ordinary) shares and some types of preference share (see 4.5 below). [IAS 32.AG13].

Whilst non-puttable shares are typically equity, an issuer of non-puttable ordinary shares nevertheless assumes a liability when it formally acts to make a distribution and becomes legally obliged to the shareholders to do so. This may be the case following the declaration of a dividend, or when, on a winding up, any assets remaining after discharging the entity's liabilities become distributable to shareholders. [IAS 32.AG13]. For example, if an entity has issued €100 million of equity instruments on which it declares a dividend of €2 million, it recognises a liability of only €2 million. Whether or not a liability arises on declaration of a dividend will depend on local legislation or the terms of the instruments or both.

IAS 32 also treats as equity instruments some puttable instruments (see 4.6.2 below) and some instruments that impose an obligation on the issuer to deliver a pro rata share of net assets only on liquidation (see 4.6.3 below) that would otherwise be classified as financial liabilities. However, a contract that is required to be settled by the entity receiving or delivering either of these types of ‘deemed’ equity instrument is a financial asset or financial liability, even when it involves the exchange of a fixed amount of cash or other financial assets for a fixed number of such instruments. [IAS 32.22A, AG13].

4.4.2 Contracts to issue equity instruments

A contract settled using equity instruments is not necessarily itself regarded as an equity instrument. The classification of contracts settled using issued equity instruments is discussed further at 5 below.

Warrants or written call options that allow the holder to subscribe for or purchase a fixed number of non-puttable common (ordinary) shares in the issuing entity in exchange for a fixed amount of cash or another financial asset, or the fixed stated principal of a bond, are classified as equity instruments. [IAS 32.22, AG13]. The meaning of a ‘fixed’ amount of cash is not as self-evident as it might appear and is discussed further at 5.2.3 below. The meaning of the ‘fixed stated principal’ of a bond is discussed further at 6.3.2.A below.

Conversely, an instrument is a financial liability (or financial asset) of the issuer if it gives the holder the right to obtain:

• a variable number of non-puttable common (ordinary) shares in the issuing entity in exchange for a fixed amount of cash or another financial asset; [IAS 32.21] or
• a fixed number of non-puttable common (ordinary) shares in the issuing entity in exchange for a variable amount of cash or another financial asset. [IAS 32.24].

An obligation for the entity to issue or purchase a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is classified as an equity instrument of the entity. However, if such a contract contains an obligation – or even a potential obligation – for the entity to pay cash or another financial asset, it gives rise to a liability for the present value of the redemption amount (which results in a reduction of equity, not an expense – see 5.3 below). [IAS 32.23, AG13].

A purchased call option or other similar contract acquired by an entity that gives it the right to reacquire a fixed number of its own equity instruments in exchange for delivering a fixed amount of cash or another financial asset is not a financial asset of the entity. Rather, it is classified as an equity instrument, and any consideration paid for such a contract is therefore deducted from equity (see 11.2.1 below). [IAS 32.22, AG14]. This requirement refers only to contracts which require the entity to settle gross (i.e. the entity pays cash in exchange for its own shares). Contracts which can be net settled (i.e. the party for whom the contract is loss-making delivers cash or shares equal to the fair value of the contract to the other party) are generally treated as financial assets or financial liabilities. This is discussed in more detail at 11 below.

4.5.1 Instruments redeemable mandatorily or at the holder's option

A preference share (or other instrument) 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,

contains a financial liability, since the issuer has an obligation, or potential obligation, to transfer cash or other financial assets to the holder. This obligation is not negated by the potential inability of an issuer to redeem a preference share when contractually required to do so, whether because of a lack of funds, a statutory restriction or insufficient profits or reserves. [IAS 32.18(a), AG25].

It is more correct to say (in the words of the application guidance) that an instrument ‘contains’ a financial liability than to say (as the main body of the standard does) that it ‘is’ a financial liability. For example, if a preference share is issued on terms that it is redeemable at the holder's option but dividends are paid entirely at the issuer's discretion, it is only the amount payable on redemption that is a liability. This would lead to a ‘split accounting’ treatment (see 6 below), whereby, at issue, the net present value of the amount payable on redemption would be classified as a liability and the balance of the issue proceeds as equity. [IAS 32.AG37].

Non-discretionary dividends, on the other hand, establish an additional liability component. In such a case there is a contractual obligation to pay cash in respect of both the redemption of the principal and the required dividend payments up to the redemption of the instrument. The liability would be recognised at an amount equal to the present value of both the redemption amount and the non-discretionary dividends. Assuming that the dividends were set at market rate, which is generally the case, this would typically result in an overall liability classification of the whole instrument. While dividend payments might be set at a fixed percentage of the nominal value, this does not need to be the case. Any non-discretionary obligation to pay dividends creates a liability that needs to be recorded on initial recognition of the instrument. If an entity has an obligation that is non-discretionary, for example to pay out a percentage of it profits, then that gives rise to a financial liability (see Chapter 46 at 2.1.3 for discussions around embedded derivatives and non-financial variables specific to one party to the contract).

4.5.2 Instruments redeemable only at the issuer's option or not redeemable

A preference share (or other instrument) redeemable in cash only at the option of the issuer does not satisfy the definition of a financial liability in IAS 32, because the issuer does not have a present or future obligation to transfer financial assets to the shareholders. In this case, redemption of the shares is solely at the discretion of the issuer. An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares. [IAS 32.AG25].

Likewise, where preference shares are non-redeemable, there is clearly no financial liability in respect of the ‘principal’ amount of the shares. In reality there may be little distinction between shares redeemable at the issuer's option and non-redeemable shares, given that in many jurisdictions an entity can ‘repurchase’ its ‘irredeemable’ shares subject to no greater restrictions than would apply to a ‘redemption’ of ‘redeemable’ shares.

Ultimately, the classification of preference shares redeemable only at the issuer's option or not redeemable according to their terms must be determined by the other rights that attach to them. IAS 32 requires the classification to be based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument. [IAS 32.AG26].

If the share does establish a contractual right to a dividend, subject only to restrictions on payment of dividends in the relevant jurisdiction, it contains a financial liability in respect of the dividends. This would lead to a ‘split accounting’ treatment (see 6 below), whereby the net present value of the right to receive dividends would be shown as a liability and the balance of the issue proceeds as equity. Where the dividends are set at a market rate at the date of issue, it is likely that the issue proceeds would be equivalent to the fair value (at the date of issue) of dividends payable in perpetuity, so that the entire proceeds would be classified as a financial liability.

However, when redemption of the preference shares and distributions to holders of the preference shares, whether cumulative or non-cumulative, are at the discretion of the issuer, the shares are equity instruments. The classification of preference share distributions as an equity component or a financial liability component is not affected by, for example:

• a history of making distributions;
• an intention to make distributions in the future;
• a possible negative impact on the price of ordinary shares of the issuer if distributions are not made (because of restrictions on paying dividends on the ordinary shares if dividends are not paid on the preference shares – see 4.5.3 below);
• the amount of the issuer's reserves;
• an issuer's expectation of a profit or loss for a period; or
• an ability or inability of the issuer to influence the amount of its profit or loss for the period. [IAS 32.AG26].

The treatment of non-redeemable preference shares or other instruments with preferred rights under IAS 32 is a particularly difficult issue, since such shares often inhabit the border territory between financial liabilities and equity instruments. However, the starting point is that a non-redeemable preference share whose dividend rights are simply that a dividend (whether of a fixed, capped or discretionary amount) will be paid at the issuing entity's sole discretion, is equivalent to an ordinary equity share and therefore appropriately characterised as equity.

4.5.3 Instruments with a ‘dividend blocker’ or a ‘dividend pusher’ clause

4.5.4 Perpetual instruments with a ‘step-up’ clause

Some perpetual instruments are issued on terms that they are not required to be redeemed. However, if they are not redeemed on or before a given future date, any coupon or dividend paid after that date is increased, usually to a level that would give rise to a cost of finance higher than the entity would normally expect to incur. This effectively compels the issuer to redeem the instrument before the increase occurs. A provision for such an increase in the coupon or dividend is colloquially referred to as a ‘step-up’ clause. A ‘step-up’ clause is often combined with a ‘dividend-blocker’ or ‘dividend pusher’ clause (see 4.5.3.A and 4.5.3.B above).

Paragraph 22 of the version of IAS 32 in issue before its revision in December 2003 (see 1.2 above) specifically addressed ‘step-up’ clauses as follows:

‘A preferred share that does not provide for mandatory redemption or redemption at the option of the holder may have a contractually provided accelerating dividend such that, within the foreseeable future, the dividend yield is scheduled to be so high that the issuer would be economically compelled to redeem the instrument.’¹¹

The Basis for Conclusions to the current version of IAS 32 indicates that this example was removed because it was insufficiently clear, but there was no intention to alter the general principle of IAS 32 that an instrument that does not explicitly establish an obligation to deliver cash or other financial assets may establish an obligation indirectly through its terms and conditions (see 4.2.2 above). [IAS 32.BC9].

This has led some to suggest that any instrument with a ‘step-up’ clause contains a financial liability. In our view, however, this is to misunderstand the reason for the IASB's decision to delete the old paragraph 22. The ‘confusion’ caused by the paragraph was that the existence of a step-up clause is in fact irrelevant to the analysis required by IAS 32. If an instrument, whether redeemable or not, contains a contractual obligation to pay a coupon or dividend, it is a liability, irrespective of the ‘step-up’ clause. However, if the coupon or dividend, both before and after the step-up date, is wholly discretionary, then the instrument is, absent other contractual terms that make it a liability, an equity instrument, again irrespective of the step-up clause (see 4.5.1 and 4.5.2 above).

This analysis was confirmed by the Interpretations Committee in March 2006 in its discussion of the classification of an instrument that included a ‘step-up’ dividend clause that would increase the dividend at a pre-determined date in the future. The Interpretations Committee agreed that this instrument included no contractual obligation ever to pay the dividends or to call the instrument and should therefore be classified as equity under IAS 32.¹²

4.5.5 Relative subordination

Some have argued that instruments with ‘dividend-blocker’, ‘dividend-pusher’ or ‘step-up’ clauses (see 4.5.3 and 4.5.4 above) do not meet the definition of an equity instrument. Those that take this view, point out that paragraph 11 of IAS 32 defines an equity instrument as ‘any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities’ (see 3 above) – whereas many instruments of the type described in 4.5.3 and 4.5.4 above are typically entitled only to a return of the amount originally subscribed on a winding up, rather than to any ‘residual interest’ in the assets. However, such an instrument does not meet the definition of a liability either, for all the reasons set out above.

Moreover, as noted at 4.1 above, IAS 32 paragraph 16 indicates that, in applying the definition in paragraph 11, an entity concludes that an instrument is equity if and only if the criteria in paragraph 16 are met. In other words, an instrument is equity if it satisfies the criteria of paragraph 16, whatever construction might be placed on paragraph 11.

In March 2006, the Interpretations Committee considered various issues relating to the classification of instruments under IAS 32, and agreed that IAS 32 was clear that the relative subordination on liquidation of a financial instrument was not relevant to its classification under IAS 32, even where the instrument ranks above an instrument classified as a liability.¹³ This supports the view that an instrument can be classified as equity even if there are restrictions on participation by its holder in a liquidation or on winding up.

However, in February 2008, the IASB issued an amendment to IAS 32 (see 1.2 above) which, in very specific circumstances, requires the relative subordination of an instrument to be taken into account in determining its classification as debt or equity (see 4.6 below).

4.5.6 Economic compulsion

The discussion in 4.5.1 to 4.5.5 above illustrates that, while IAS 32 requires the issuer of a financial instrument to classify a financial instrument by reference to its substance rather than its legal form, in reality the substance is determined, if not by the legal form, then certainly by the precise legal rights of the holder of the financial instrument concerned. Ultimately, the key determinant of whether an instrument is a financial liability or an equity instrument of the issuer is whether the terms of the instrument give the holder a contractual right to receive cash or other financial assets which can be sued for at law, subject only to restrictions outside the terms of the instrument (e.g. statutory dividend controls).

By contrast, terms of an instrument that effectively force the issuer to transfer cash or other financial assets to the holder although not legally required to do so (often referred to as ‘economic compulsion’), are not taken into account.

In response to a submission for a possible agenda item, in March 2006 the Interpretations Committee discussed the role of contractual and economic obligations in the classification of financial instruments under IAS 32.

The Interpretations Committee agreed that IAS 32 is clear that, in order for an instrument to be classified as a liability, a contractual obligation must be established (either explicitly or indirectly) through the terms and conditions of the instrument. Economic compulsion, by itself, would not result in a financial instrument being classified as a liability.

The Interpretations Committee also noted that IAS 32 restricts the role of ‘substance’ to consideration of the contractual terms of an instrument, and that anything outside the contractual terms is not considered for the purpose of assessing whether an instrument should be classified as a liability under IAS 32.¹⁴

4.5.7 ‘Linked’ instruments

An entity may issue an instrument (the ‘base’ instrument) that requires a payment to be made if, and only if, a payment is made on another instrument issued by the entity (the ‘linked’ instrument). An example of such an instrument would be a perpetual instrument with a ‘dividend blocker’ clause (see 4.5.3.A above), on which the issuing entity is required to pay a coupon only if it pays a dividend to ordinary shareholders. Absent other terms requiring the perpetual instrument to be classified as a liability, it is classified as equity on the basis that the event that triggers a contractual obligation to make a payment (i.e. payment of an ordinary dividend) is itself not a contractual obligation.

If, however, where payments on the linked instrument are contractually mandatory (such that the linked instrument contains a liability), it is obvious that the base instrument must also contain a liability. This is due to the fact that, in this case, the event that triggers a contractual obligation to make a payment on the base instrument (i.e. a payment on the linked instrument) is a contractual obligation that the issuing entity cannot avoid. This analysis was confirmed by the Interpretations Committee in March 2006 following discussion of linked instruments with similar terms to these.¹⁵

This issue had arisen in practice in the context that the linked instrument was often very small and callable by the issuer, but on terms that required its classification as a liability under IAS 32. This would allow the issuer, with no real difficulty, to redeem the linked instrument at will and thus convert the base instrument from a liability to equity at any time. This had led some to argue that only the linked instrument should be classified as a liability.

4.5.8 ‘Change of control’, ‘taxation change’ and ‘regulatory change’ clauses

A number of entities have issued instruments with ‘dividend blocker’, ‘dividend pusher’ and ‘step-up’ clauses (see 4.5.3 and 4.5.4 above), which would otherwise have been treated as equity by IAS 32, but have wished to account for them as liabilities, perhaps because they can then be hedged in a way that allows hedge accounting to be applied (see 10 below). Methods of achieving this have included the use of a de minimis linked liability instrument, or the inclusion of a clause requiring the repayment of the instrument in the event of a change of control. This raises the question of whether a change of control is within the control of the entity (such that the instrument is equity) or not (such that the instrument is debt), which is discussed in more detail at 4.3.3 above.

Another common method of converting an instrument that would otherwise be classified by IAS 32 as equity into debt is to add a clause requiring repayment of the instrument in the event of a fiscal or regulatory change (that in reality may be a remote possibility) – see 4.3.1 above.

4.6.1 The issue

A ‘puttable instrument’ is essentially a financial instrument that gives the holder the right to put the instrument back to the issuer for cash or another financial asset (see 3 above). Prior to its amendment in February 2008 (see 1.2 above), IAS 32 classified any puttable instrument as a financial liability, including instruments the legal form of which gives the holder a right to a residual interest in the assets of the issuer.

This classification produced what some regarded as an inappropriate result in the financial statements of entities such as open-ended mutual funds, unit trusts, partnerships and some co-operative entities. Such entities often provide their unit holders or members with a right to redeem their interests in the issuer at any time for cash. Under IAS 32, prior to the February 2008 amendment, an entity whose holders had such rights might report net assets of nil, or even negative net assets, since what would, in normal usage, have been regarded as its ‘equity’ (i.e. assets less external borrowings) was classified as a financial liability.

For example, the owners of some co-operatives and professional partnerships are entitled to have their ownership interests repurchased at fair value. However, such entities typically do not reflect that fair value in their financial statements, because a significant part of the value may be represented by property accounted for at cost rather than fair value or by internally generated goodwill which cannot be recognised in financial statements prepared under IFRS.

Clearly, if such an entity were to recognise a liability for the right of its owners to be bought out at fair value, it would show net liabilities, which would increase (creating accounting losses) the more the fair value of the entity increases, and decrease (creating accounting profits) the more the fair value decreases. Moreover, any distributions to the owners of such entities would be shown as a charge to, rather than a distribution of, profit.

Similar concerns were raised in relation to limited-life entities. In some jurisdictions, certain types of entity are required to be wound up after a certain period of time, either automatically, or unless the members resolve otherwise. Some entities may also have a limited life under their own governing charter, or equivalent document. For example:

• a collective investment fund might be required to be liquidated on, say, the tenth anniversary of its foundation; or
• a partnership might be required to be dissolved on the death or retirement of a partner.

Such an entity arguably had no equity under IAS 32 prior to the February 2008 amendment, since its limited life imposes an obligation, outside the entity's control, to distribute all its assets. Again, some questioned whether it was very meaningful to show such an entity as having no equity.

In order to deal with these concerns, IAS 32 was amended in February 2008. In the meantime, the Interpretations Committee had published IFRIC 2 which addresses the narrower issue of the classification of certain types of puttable instrument typically issued by co-operative entities (see 4.6.6 below).

The effect of the amended standard is that certain narrowly-defined categories of puttable instruments (see 4.6.2 below) and instruments repayable on a pre-determined liquidation (see 4.6.3 below) are classified as equity, notwithstanding that they have features that would otherwise require their classification as financial liabilities.

Moreover, as discussed further at 4.6.5 below, one of the criteria for classifying such an instrument as equity, is that it is the most subordinated instrument issued by the reporting entity. This represents a significant, and controversial, departure from the normal approach of IAS 32 that the classification of an instrument should be determined only by reference to the contractual terms of that instrument, rather than those of other instruments in issue. This may mean that two entities may classify an identical instrument differently, if it is the most subordinated instrument of one entity but not of the other. It may also mean that the same entity may classify the same instrument differently at different reporting dates.

It was essentially these departures from the normal requirements of IAS 32 that led two members of the IASB to dissent from the amendment. In their view, it is not based on a clear principle, but comprises ‘several paragraphs of detailed rules crafted to achieve a desired accounting result … [and] … to minimise structuring opportunities’.¹⁶

Where the exceptions in 4.6.2 and 4.6.3 below do not apply, IAS 32 takes the view that the effect of the holder's option to put the instrument back to the issuer for cash or another financial asset is that the puttable instrument meets the definition of a financial liability, [IAS 32.18(b)], (see 3 above).

The IASB believes that the accounting treatment required by IAS 32 for instruments not subject to the exceptions in 4.6.2 and 4.6.3 below is appropriate, but points out that the classification of members' interests in such entities as a financial liability does not preclude:

• the use of captions such as ‘net asset value attributable to unitholders’ and ‘change in net asset value attributable to unitholders’ on the face of the financial statements of an entity that has no equity capital (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. [IAS 32.18(b), BC7‑BC8].

The illustrative examples appended to IAS 32 give specimen disclosures to be used in such cases – see Chapter 54 at 7.4.6.

4.6.2 Puttable instruments

As noted above, 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. IAS 32 classifies a puttable instrument as an equity instrument if it has all of the following features: [IAS 32.16A-16B]

1. It entitles the holder to a pro rata share of the entity's net assets in the event of the entity's liquidation. The entity's net assets are those assets that remain after deducting all other claims on its assets. A pro rata share is determined by:
   1. dividing the entity's net assets on liquidation into units of equal amount; and
   2. 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:
   1. has no priority over other claims to the assets of the entity on liquidation; and
   2. 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 entity, or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity, and it is not a contract that will or may be settled in the entity's own equity instruments as set out in subparagraph (b) of the definition of a financial liability (see 3 above).
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 entity over the life of the instrument (excluding any effects of the instrument). [IAS 32.16A]. Profit or loss and the change in recognised net assets must be determined in accordance with relevant IFRSs. [IAS 32.AG14E].
6. In addition to the instrument having all the features in (a) to (e) above, 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 entity (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.

   In applying this condition, the entity should not consider non-financial contracts with a holder of an instrument described in (a) to (e) above 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 entity. If the entity cannot determine that this condition is met, it should not classify the puttable instrument as an equity instrument. [IAS 32.16B].

Some of these criteria raise issues of interpretation, which are addressed at 4.6.4 below.

4.6.3 Instruments entitling the holder to a pro rata share of net assets only on liquidation

Some financial instruments include a contractual obligation for the issuing entity to deliver to another entity 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 entity (for example, a limited life entity) or is uncertain to occur but is at the option of the instrument holder. IAS 32 classifies such an instrument as an equity instrument if it has all of the following features: [IAS 32.16C-16D]

1. It entitles the holder to a pro rata share of the entity's net assets in the event of the entity's liquidation. The entity's net assets are those assets that remain after deducting all other claims on its assets. A pro rata share is determined by:
   1. dividing the net assets of the entity on liquidation into units of equal amount; and
   2. 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:
   1. has no priority over other claims to the assets of the entity on liquidation; and
   2. 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 entity to deliver a pro rata share of its net assets on liquidation. [IAS 32.16C].
4. In addition to the instrument having all the features in (a) to (c) above, 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 entity (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 entity should not consider non-financial contracts with a holder of an instrument described in (a) to (c) above 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 entity. If the entity cannot determine that this condition is met, it should not classify the instrument as an equity instrument. [IAS 32.16D].

Some of these criteria raise some issues of interpretation, which are addressed at 4.6.4 below.

Some of the criteria for classifying as equity financial instruments that entitle the holder to a pro rata share of assets only on liquidation are similar to those (in 4.6.2 above) for classifying certain puttable instruments as equity. The difference between these criteria and those for puttable instruments are:

• there is no requirement for there to be no contractual obligations other than those arising on liquidation;
• there is no requirement to consider the expected total cash flows throughout the life of the instrument; and
• the only feature that must be identical among the instruments in the class is the obligation for the issuing entity to deliver to the holder a pro rata share of its net assets on liquidation.

The reason for the more relaxed criteria in this case is that the IASB took the view that, given that the only obligation in this case arises on liquidation, there was no need to consider obligations other than those on liquidation. However, the IASB notes that, if an instrument does contain other obligations, these may need to be accounted for separately under IAS 32. [IAS 32.BC67].

4.6.4 Clarification of the exemptions in 4.6.2 and 4.6.3 above

The conditions for treating certain types of puttable instruments (see 4.6.2 above) and instruments repaying a pro rata share of net assets on liquidation (see 4.6.3 above) as equity are complex. IAS 32 provides some clarification in respect of the following matters:

• instruments issued by a subsidiary (see 4.6.4.A below);
• determining the level of subordination of an instrument (see condition (b) under 4.6.2 and 4.6.3 above), (see 4.6.4.B below);
• the meaning of ‘no obligation to deliver cash or another financial asset’ (see condition (d) under 4.6.2 above) in respect of instruments with a requirement to distribute a minimum proportion of profit to shareholders (see 4.6.4.D below);
• other instruments that substantially fix or restrict the residual return to the holder of an instrument (see condition (f)(ii) in 4.6.2 above and condition (d)(ii) in 4.6.3 above), (see 4.6.4.E below); and
• transactions entered into by an instrument holder other than as owner of the entity (see 4.6.4.F below).

One matter on which IAS 32 does not provide further clarification is the meaning of ‘identical features’ (see condition (c) under 4.6.2 above). This is dealt with in 4.6.4.C below.

4.6.5 Reclassification of puttable instruments and instruments imposing an obligation only on liquidation

As noted in 4.6.4.B above, IAS 32 requires the entity to continually reassess the classification of such an instrument. The entity classifies a financial instrument as an equity instrument from the date on which it has all the features and meets the conditions set out in 4.6.2 or 4.6.3 above, and reclassifies the instrument from the date on which it ceases to have all those features or meet all those conditions.

For example, if an entity redeems all its issued non-puttable instruments, any puttable instruments that remain outstanding and that have all of the features and meet all the conditions in 4.6.2 above, are reclassified as equity instruments from the date of redemption of the non-puttable instruments. [IAS 32.16E].

Where an instrument, previously classified as an equity instrument, is reclassified as a financial liability, the financial liability is measured at fair value at the date of reclassification, with any difference between the carrying value of the equity instrument and the fair value of the financial liability at the date of reclassification being recognised in equity. [IAS 32.16F(a)].

Where an instrument, previously classified as a financial liability, is reclassified as an equity instrument, the equity instrument is measured at the carrying value of the financial liability at the date of reclassification. [IAS 32.16F(b)].

4.6.6 IFRIC 2

The issue that ultimately led to the publication of IFRIC 2 was the appropriate accounting treatment for the members' contributed capital of a co-operative entity, the members of which are entitled to ask for the return of their investment. However, the scope of IFRIC 2 is not confined to co-operative entities, and extends to any entity whose members may ask for a return of their capital. [IFRIC 2.1‑4].

IFRIC 2 states that the contractual right of the holder of a financial instrument to request redemption does not, in itself, require that financial instrument to be classified as a financial liability. Rather, the entity must consider all of the terms and conditions of the financial instrument in determining its classification as a financial liability or equity. Those terms and conditions include relevant local laws, regulations and the entity's governing charter in effect at the date of classification, but not expected future amendments to those laws, regulations or charter. [IFRIC 2.5].

Accordingly, IFRIC 2 provides that an instrument, that would be classified as equity if the holder did not have the right to request redemption, should be classified as an equity instrument where:

• the entity has the unconditional right to refuse redemption;
• local law, regulation or the entity's governing charter imposes an unconditional prohibition on redemption; or
• the members' shares meet the criteria in 4.6.2 or 4.6.3 above for classification as equity. [IFRIC 2.6‑8].

IFRIC 2 distinguishes between those prohibitions on redemption in local law, regulation or the entity's governing charter that are ‘unconditional’ (i.e. they apply at any time) and those which prohibit redemption only when certain conditions – such as liquidity constraints – are met or not met. Prohibitions that apply only in certain circumstances are ignored and therefore would not result in equity classification. [IFRIC 2.8]. This is consistent with the fact that under IAS 32 the classification of an instrument as debt or equity is not influenced by considerations of liquidity (see 4.2 above).

In some cases, there may be a partial prohibition on redemption. For example, redemption may be prohibited where its effect would be to reduce the number of members' shares or the amount of paid-in capital below a certain minimum. In such cases, only the amount subject to a prohibition on redemption is treated as equity, unless:

• the entity has the unconditional right to refuse redemption as described above; or
• the members' shares meet the criteria in 4.6.2 or 4.6.3 above for classification as equity.

If the minimum number of members' shares or amount of paid-in capital changes, an appropriate transfer is made between financial liabilities and equity. [IFRIC 2.9].

Any financial liability for the redemption of instruments not classified as equity is measured at fair value. In the case of members' shares with a redemption feature, the entity measures the fair value of the financial liability for redemption at no less than the maximum amount payable under the redemption provisions of its governing charter or applicable law, discounted from the first date that the amount could be required to be paid. [IFRIC 2.10].

In accordance with the general provisions of IAS 32 regarding interest and dividends (see 8 below), distributions to holders of equity instruments are recognised directly in equity, net of any income tax benefits. Interest, dividends and other returns relating to financial instruments classified as financial liabilities are expenses, regardless of whether those amounts paid are legally characterised as dividends, interest or otherwise. [IFRIC 2.11].

IFRIC 2 clarifies that, where members act as customers of the entity (for example, where it is a bank and members have current or deposit accounts or similar contracts with the bank), such accounts and contracts are financial liabilities of the entity. [IFRIC 2.6].

It should be noted that in the FICE DP (see 12 below), the IASB noted that the IFRS requirements to account for financial instruments have been designed around the concept of a contract. They further noted that IFRIC 2 was developed for a very specific fact pattern and that they did not believe that the analysis in IFRIC 2 should be applied more broadly.¹⁸

4.8.1 Consolidated financial statements

In consolidated financial statements, IAS 32 requires an entity to present non-controlling interests (i.e. the interests of other parties in the equity and income of its subsidiaries) within equity, in accordance with IAS 1 – Presentation of Financial Statements (see Chapter 3 at 3.1.5) and IFRS 10 – Consolidated Financial Statements (see Chapter 7 at 4 and Chapter 9 at 8). [IAS 32.AG29].

When classifying a financial instrument (or a component of it) in consolidated financial statements, an entity must consider all the terms and conditions agreed between all members of the group and the holders of the instrument in determining whether the group as a whole has an obligation to deliver cash or another financial asset in respect of the instrument or to settle it in a manner that results in its classification as a financial liability. [IAS 32.AG29].

For example, a subsidiary in a group may issue a financial instrument and a parent or other group entity may then agree additional terms directly with the holders of the instrument so as to guarantee some or all of the payments to be made under the instrument. The effect of this is that the subsidiary may have discretion over distributions or redemption, but the group as a whole does not. [IAS 32.AG29].

Accordingly, the subsidiary may appropriately classify the instrument without regard to these additional terms in its individual financial statements. For the purposes of the consolidated financial statements, however, the effect of the other agreements between members of the group and the holders of the instrument is to create an obligation or settlement provision, so that the instrument (or the component of it that is subject to the obligation) is classified as a financial liability. [IAS 32.AG29].

Thus it is quite possible for a financial instrument to be classified as an equity instrument in the financial statements of the issuing subsidiary but as a financial liability in the financial statements of the group.

4.8.2 Single entity financial statements

The converse of the discussion in 4.8.1 above is that it is not uncommon for instruments that are classified as equity in the consolidated financial statements to give rise to liabilities and embedded derivatives in the financial statements of individual members of the group.

This is because a group wishing to raise finance for its operations will generally do so through a group entity specialising in finance-raising, which will then on-lend the proceeds of the finance raised to the relevant operating subsidiaries. The terms of the intragroup on-lending transactions will often be such that finance which constitutes equity from the perspective of group as a whole may be a liability in the individual financial statements of the finance-raising entity itself.

For example, the finance-raising entity might issue an irredeemable instrument with a ‘dividend blocker’ clause (see 4.5.3.A above), under the terms of which that entity is not required to make any payments to the holder unless the ultimate parent entity of the group pays a dividend to ordinary shareholders. Absent any other terms requiring its classification, in whole or in part, as a liability under IAS 32, the instrument will be treated as equity in the consolidated financial statements, since payments under the instrument are contingent on an event within the control of the group (payment of a dividend by the parent entity). In the finance-raising entity's single entity financial statements, however, the instrument should be classified as a liability, because the subsidiary cannot control the dividend policy of its parent and could therefore be forced to make payments to the holder of the instrument as a consequence of its parent entity paying a dividend.

Another common example is that a group may issue a convertible bond which is actually structured as a series of transactions along the following lines:

• a finance-raising subsidiary issues a bond, giving the holder a right to receive fixed, non-discretionary interest payments, which converts into preference shares of that subsidiary; and
• at the time that this conversion occurs, the parent entity is required to acquire the preference shares of the subsidiary from the holder (i.e. the previous bondholder) in exchange for equity of the parent.

Absent any other terms requiring classification as a liability under IAS 32, the instrument will be treated as a compound instrument, consisting of a liability and an equity component (see 6 below) in the consolidated financial statements. The instrument as a whole might be classified as a liability in the subsidiaries financial statements, if (for example) the preference shares issued on conversion by the subsidiary have terms that require them to be classified as a liability by IAS 32. In that case, the subsidiary will have issued an instrument that the holder can exchange either for cash or for a debt instrument.

From the subsidiary's perspective, therefore, there is no equity component to the instrument and the overall instrument would be classified as a liability that, under the general rules of IFRS 9, must be recorded at fair value on initial recognition, which will typically be lower than the proceeds received. This is because the pricing of the instrument as a whole considers the conversion option that the holder receives, so that the interest is typically paid at a rate below the rate that would apply to a liability without a conversion option. In other words, the holder of the instrument ‘pays’ for the conversion option through a reduced entitlement to interest.

The group accounts reflect the difference between the proceeds of issue and the fair value of the liability component as the equity component (see 6 below). In the financial statements of the issuing subsidiary, the most appropriate accounting treatment, in our view, would be to treat this difference as an equity contribution by the parent, reflecting the fact that the subsidiary can borrow on a reduced interest basis due to the conversion option issued by the parent. Moreover, in the period prior to conversion, the parent is required to account for its contingent forward contract to acquire the preference shares in the finance company.

4.9.1 Change of terms

IAS 32 gives no guidance as to whether reclassification is required, permitted or prohibited. The requirement of IAS 32 paragraph 15 that an instrument be classified ‘on initial recognition’ (see 4 above) could be read as implying that classification occurs only on initial recognition and is not subsequently revisited.

However, we do not consider this an appropriate analysis. A change in the terms of an instrument is equivalent to the issue of a new instrument in settlement of the original instrument. Such an exchange transaction would be accounted for by derecognising the settled instrument and recognising (and classifying as a financial liability or equity) the new replacement instrument. This analysis has been confirmed by an agenda decision of the Interpretations Committee (see 4.9.1.A below). In our view, it would be inappropriate to apply a different accounting treatment to a change in the terms of the original instrument which has the same economic result.

4.9.2 Change of circumstances

The nature and risk profile of a financial instrument may change as a result of a change in circumstances. Such a change may occur simply as the result of the passage of time. For example, in 2018 an entity might issue a bond mandatorily convertible at the end of 2021. The conversion terms are that the holder will receive a number of the issuer's equity shares, being the lower of 100 shares or a number of shares determined according to a formula based on the share price at 31 December 2018.

At the date of issue, this instrument is a financial liability since it involves an obligation to deliver a variable number of equity instruments. At 31 December 2018, however, the number of shares to be delivered on conversion can be determined and becomes fixed. Accordingly, if considered as at 31 December 2018 and later, the instrument is an equity instrument (absent any other terms requiring its continued classification as financial liability).

In our view, the liability component of the bond representing the obligation to deliver a variable number of equity instruments on 31 December 2021 expires on 31 December 2018. This liability component must therefore be derecognised (see Chapter 52 at 6), to be replaced with an equity component (see the discussion at 7 below of the appropriate accounting treatment in such circumstances).

Changes of circumstances for reasons other than the passage of time are more challenging. For example, an entity might issue a convertible bond denominated in its functional currency at that time. Such a bond would have an equity component (see 6 below). Subsequently, the entity's functional currency changes but the bond remains outstanding, now denominated in a currency other than the entity's functional currency. If a bond with these terms were issued after the change in functional currency, it would be classified in its entirety as a financial liability, since the principal of the bond would not be a ‘fixed’ amount by reference to the entity's functional currency (see 5.2.3 below). This raises the question of whether the equity component of the bond should be reclassified as a financial liability on the change in functional currency.

In our view, there are arguments both for and against reclassification. As the arguments for reclassification are to some extent a rebuttal of those against reclassification, we discuss the latter first.

5.1 Contracts accounted for as equity instruments

A contract that will be settled by the entity delivering or receiving a fixed number of its own equity instruments in exchange for a fixed amount of cash (see 5 above) or another financial asset is an equity instrument, although a liability may be recorded for any cash payable, by the entity on settlement of the contract. An example would be an issued share option that gives the counterparty a right to buy a fixed number of the entity's shares for a fixed price or for a fixed stated principal amount of a bond (see 6.3.2.A below). [IAS 32.22].

The fair value of such a contract may change due to variations in market interest rates and the share price. However, provided that such changes in fair value 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, the contract is an equity instrument and accounted for as such. [IAS 32.22].

Any consideration received (such as the premium received for a written option or warrant on the entity'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 financial statements. [IAS 32.22, AG27(a)].

IAS 32 requires some types of puttable instruments (see 4.6.2 above) and instruments that impose an obligation to deliver a pro rata share of net assets only on liquidation (see 4.6.3 above) to be treated as equity instruments. However, a contract that is required to be settled by the entity receiving or delivering either of these types of equity instrument is a financial asset or financial liability, even when it involves the exchange of a fixed amount of cash or other financial assets for a fixed number of such instruments. [IAS 32.22A, AG13].

5.2 Contracts accounted for as financial assets or financial liabilities

5.3 Liabilities arising from gross-settled contracts for the purchase of the entity's own equity instruments

The following discussion relates only to contracts that must be settled by the counterparty delivering equity instruments (other than those classified as such under the exceptions discussed at 4.6 above) and the entity paying cash (gross-settled contracts). Contracts which can be settled net (i.e. by payment of the difference between the fair value, at the time of settlement, of the equity instruments and that of the consideration given) are accounted for as financial assets or financial liabilities, [IAS 32.AG27(c)], (see 5.2.8 above and 11 below).

IAS 32 requires some types of puttable instruments (see 4.6.2 above) and instruments that impose an obligation to deliver a pro rata share of net assets only on liquidation (see 4.6.3 above) to be treated as equity instruments. However, a contract that is required to be settled by the entity receiving or delivering either of these types of equity instrument is a financial asset or financial liability, even when it involves the exchange of a fixed amount of cash or other financial assets for a fixed number of such instruments. [IAS 32.22A, AG27].

Entering into a gross-settled contract for the purchase of own equity instruments gives rise to a financial liability in respect of the obligation to pay the purchase or redemption price, [IAS 32.23, AG27(a)-(b)], (but resulting, on initial recognition, in a reduction of equity rather than an expense). This treatment is intended to reflect the idea that a forward contract or written option to repurchase an equity share gives rise to a liability similar to that contained within a redeemable share (see 4.5 above and 11 below). [IAS 32.BC12].

This is the case even if:

• the contract is an equity instrument;
• the contract is a written put option (i.e. a contract that gives the counterparty the right to require the entity to buy its own shares) rather than a forward contract (i.e. a firm commitment by the entity to purchase its own shares); or
• the number of shares subject to the contract is not fixed. [IAS 32.23, AG27(a)-(b)].

The final bullet point above might refer to a put option written by the entity whereby the counterparty can require the entity to purchase between 1,000 and 5,000 of its own equity shares at €2 per share. In other words, the entity cannot avoid recognising a liability for the contract on the argument that it does not know exactly how many of its own shares it will be compelled to purchase.

When such a liability first arises it must be recognised, in accordance with IFRS 9, at its fair value, i.e. the net present value of the redemption amount. Subsequently, the financial liability is measured in accordance with IFRS 9 (see Chapter 50). [IAS 32.23, AG27(b)]. IAS 32 offers no guidance as to how this is to be calculated when, as might be the case with respect to a written put option such as that described in the previous paragraph, the number of shares to be purchased and/or the date of purchase is not known.

In our view, it would be consistent with the requirement of IFRS 13 that liabilities with a demand feature such as a demand bank deposit should be measured at the amount payable on demand, [IFRS 13.47], (see Chapter 14 at 11.5) to adopt a ‘worst case’ approach. In other words, it should be assumed that the purchase will take place on the earliest possible date for the maximum number of shares. This is also consistent with IAS 32's emphasis, in the general discussion of the differences between liabilities and equity instruments, on a liability arising except to the extent that an entity has an ‘unconditional’ right to avoid delivering cash or other financial assets (see 4.2 above).

The treatment proposed in the previous paragraph would lead to a different accounting treatment for written ‘American’ put options (i.e. those that can be exercised at any time during a period ending on a future date) and written ‘European’ put options (i.e. those that can be exercised only at a given future date). In the case of an American option, a liability would be recorded immediately for the full potential liability. In the case of a European option, a liability would be recorded for the net present value of the full potential liability, on which interest would be accrued until the date of potential exercise. If this interpretation is correct, it has the effect that:

• a gross-settled written American put option that is an equity instrument has no effect on profit or loss (because the full amount payable on settlement would be charged to equity on inception of the contract); but
• a gross-settled European put option that is an equity instrument does affect profit or loss (because the net present value of the amount payable on settlement would be charged to equity on inception of the contract and accrued to the full settlement amount through profit or loss).

If the contract expires without delivery of the shares, the carrying amount of the financial liability is reclassified to equity. This has the rather curious effect that a share purchase contract that expires unexercised (and therefore has no impact on the entity's net assets, other than the receipt or payment of the option premium) can nevertheless give rise to a loss to the extent that interest has been recognised on the liability between initial recognition and its transfer to equity (see Example 47.22 at 11.3.2 below).

5.4 Gross-settled contracts for the sale or issue of the entity's own equity instruments

The following discussion in 5.4 relates only to contracts which must be settled by the entity delivering its own equity instruments (other than those classified as such under the exceptions discussed at 4.6 above) and the counterparty paying cash (gross-settled contracts). Contracts which can be settled net (i.e. by payment of the difference between the fair value, at the time of purchase, of the shares and that of the consideration given) are accounted as financial assets or financial liabilities (see 5.2.7 above). [IAS 32.AG27(c)].

IAS 32 requires some types of puttable instruments (see 4.6.2 above) and instruments that impose an obligation to deliver a pro rata share of net assets only on liquidation (see 4.6.3 above) to be treated as equity instruments. However, a contract that is required to be settled by the entity receiving or delivering either of these types of equity instrument is a financial asset or financial liability, even when it involves the exchange of a fixed amount of cash or other financial assets for a fixed number of such instruments. [IAS 32.22A, AG27].

If an entity enters into a gross-settled contract to sell its own equity instruments, the contract is economically the ‘mirror image’ of a contract for the purchase of own equity. However, there is no provision in IAS 32 that the contract gives rise to a financial asset in respect of the cash to be received from the counterparty, as compared to the specific provision that a contract to purchase own equity gives rise to a financial liability in respect of the cash to be paid to the counterparty (see 5.3 above). Consequently, it appears that such contracts give rise to no accounting entries until settlement. This analysis is confirmed by an illustrative example to IAS 32 (see Example 47.17 at 11.1.2 below).

Contracts for the sale or issue of an entity's own equity arise in situations such as those in Example 47.2 and 47.3 below.

One view might be that the situation in Example 47.2 is not a contract for the future issue of equity – the share has already been issued, and so it would be quite appropriate to record a receivable for the deferred subscription payments. The accounting standard IFRS for Small and Medium-Sized Entities indicates that a receivable should be recognised only for shares that have been issued, but that such a receivable should be recognised as a deduction from equity, not as an asset.²² The standard states that this proposal is derived from IAS 32²³ – an assertion difficult to reconcile with the discussion above. Interestingly, an early IASB staff draft of the exposure draft of IFRS for Small and Medium-Sized Entities (as made available on the IASB's website as at September 2006) admitted, with perhaps unintended candour, that this treatment is ‘not in any standard’!²⁴ In our view, current IFRS requires any receivable recognised in respect of an issued share to be shown as an asset.

On the other hand, it is clear from IAS 32 that no receivable would be recognised if the arrangement provided for the entity actually to issue further shares (pro rata to the shares initially issued) for €1 on 1 January 2019 and 1 January 2020.

6.1 Background

While many financial instruments are either a liability or equity in their entirety, that is not true for all financial instruments issued by an entity. Some, referred to as compound instruments in IAS 32, contain both elements. A compound financial instrument is a non-derivative financial instrument that, from the issuer's perspective, contains both a liability and an equity component. [IAS 32.28, AG30]. Examples include:

• A bond, in the same currency as the functional currency of the issuing entity, convertible into a fixed number of equity instruments, which effectively comprises:
  • a financial liability (the issuer's obligation to pay interest and, potentially, to redeem the bond in cash); and
  • an equity instrument (the holder's right to call for shares of the issuer).

    IAS 32 states that the economic effect of issuing such an instrument is substantially the same as simultaneously issuing a debt instrument with an early settlement provision and warrants to purchase ordinary shares, or issuing a debt instrument with detachable share purchase warrants. [IAS 32.29]. However, this analysis is questionable in the sense that, if a company did issue such instruments separately, it is extremely unlikely that one would lapse as the result of the exercise of the other (as is the case on the conversion or redemption of a convertible bond);

• A mandatorily redeemable preference share with dividends paid at the issuer's discretion, which effectively comprises:
  • a financial liability (the issuer's obligation to redeem the shares in cash); and
  • an equity instrument (the holder's right to receive dividends if declared). [IAS 32.AG37].

IAS 32 requires the issuer of a non-derivative financial instrument to evaluate the terms of the financial instrument to determine whether it contains both a liability and an equity component. This evaluation is based on the contractual terms of the financial instruments, the substance of the arrangement and the definition of a financial liability, financial asset and an equity instrument. If such components are identified, they must be accounted for separately as financial liabilities, financial assets or equity, [IAS 32.28], and the liability and equity components shown separately in the statement of financial position. [IAS 32.29].

This treatment, commonly referred to as ‘split accounting’, is discussed in more detail in 6.2 to 6.6 below. For simplicity, the discussion below (like that in IAS 32 itself) is framed in terms of convertible bonds, by far the most common form of compound financial instrument, but is equally applicable to other types of compound instrument, such as preference shares with different contractual terms in respect of dividends and re-payments of principal (see 4.5 above).

6.2 Initial recognition – ‘split accounting’

On initial recognition of a compound instrument such as a convertible bond, IAS 32 requires the issuer to:

1. identify the various components of the instrument;
2. determine the fair value of the liability component (see below); and
3. determine the equity component as a residual amount, essentially the issue proceeds of the instrument less the liability component determined in (b) above.

The liability component of a convertible bond should be measured first, at the fair value of a similar liability that does not have an associated equity conversion feature, but including any embedded non-equity derivative features, such as an issuer's or holder's right to require early redemption of the bond, if any such terms are included.

In practical terms, this will be done by determining the net present value of all potential contractually determined future cash flows under the instrument, discounted at the rate of interest applied by the market at the time of issue to instruments of comparable credit status and providing substantially the same cash flows, on the same terms, but without the conversion option. The fair value of any embedded non-equity derivative features is then determined and ‘included in the liability component’ – see, however, the further discussion of this point at 6.4.2 below. [IAS 32.31].

Thereafter the liability component is accounted for in accordance with the requirements of IFRS 9, for the measurement of financial liabilities (see Chapter 50). [IAS 32.31‑32].

IAS 32 notes that:

• the equity component of a convertible bond is an embedded option to convert the liability into equity of the issuer;
• the fair value of the option comprises its time value and its intrinsic value, if any; and
• this option has value on initial recognition even when it is out of the money. [IAS 32.AG31(b)].

However, not all these features are directly relevant to the accounting treatment, since the equity component is not (other than by coincidence) recorded at its fair value. Instead, in accordance with the general definition of equity as a residual, the equity component of the bond is simply the difference between the fair value of the compound instrument (total issue proceeds of the bond) and the liability component as determined above. Because of this ‘residual’ treatment, IAS 32 does not address the issue of how, or whether, the issue proceeds are to be allocated where more than one equity component is identified. It is important to note, that the equity component will not be remeasured subsequently.

The methodology of ‘split-accounting’ in IAS 32 has the effect that 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 the initial recognition of the separate components of the instrument. [IAS 32.31].

This treatment is illustrated in Examples 47.4 and 47.8 below. [IAS 32.IE34‑36].

6.3 Conversion, early repurchase and modification

6.4 The components of a compound instrument

6.5 Other issues

The following issues discussed earlier in this chapter are of particular relevance to convertible bonds:

• the Interpretations Committee's conclusion that a fixed amount of cash denominated in a currency other than the entity's functional currency is not a ‘fixed amount’ of cash (see 5.2.3 above and 6.4.4 and 6.6.4.A below); and
• the treatment of instruments settled with equity instruments the number of which varies to reflect major capital restructurings before settlement (see 5.1.2 above).

These and other issues noted at various points above reinforce an increasing concern that the ‘split accounting’ rules in IAS 32 are implicitly based on a bond with terms much more straightforward than those of many – if not most – bonds currently in issue. See 12 below for possible future developments.

6.6 Common forms of convertible bonds

7.1 Scope and effective date of IFRIC 19

IFRIC 19 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 to extinguish all or part of the financial liability. It does not address the accounting by the creditor. [IFRIC 19.2].

Further, the interpretation does not apply to transactions in situations where: [IFRIC 19.3]

• the creditor is also a direct or indirect shareholder and is acting in its capacity as a direct or indirect existing shareholder (see 7.3 below);
• 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 (see 7.3 below); or
• the extinguishment of the financial liability by issuing equity shares is in accordance with the original terms of the financial liability. This will most commonly arise on conversion of a convertible bond that has been subject to ‘split accounting’, the accounting for which is covered at 6 above.

7.2 Requirements of IFRIC 19

Equity instruments issued to a creditor to extinguish all or part of a financial liability are treated as consideration paid and should normally be measured at their fair value at the date of extinguishment. However, if that fair value cannot be reliably measured, the equity instruments should be measured to reflect the fair value of the financial liability extinguished. The difference between the carrying amount of the financial liability and the consideration paid (including the equity instruments issued) should be recognised in profit or loss and should be disclosed separately. [IFRIC 19.5‑7, 9, 11].

These requirements are illustrated in the following simple example.

Debt for equity swaps often take place in situations when the terms of the financial liability such as covenants are breached and the liability has become, or will become, repayable on demand. Normally, the fair value of a financial liability with a demand feature is required by IFRS 13 to be measured at no less than the amount payable on demand, discounted from the first date that the amount could be required to be paid (see Chapter 14 at 11.5). However, in the IASB's view, the fact that a debt for equity swap has occurred indicates that the demand feature is no longer substantive. Consequently, where the fair value of the equity instruments issued is based on the fair value of the liability extinguished, this particular aspect of IFRS 13 is not applied. [IFRIC 19.7, BC22].

If only part of the financial liability is extinguished, some of the consideration paid might relate to a modification of the terms of the liability that remains outstanding. If so, the consideration paid should be allocated between the part of the liability extinguished and the part of the liability that remains outstanding. All relevant facts and circumstances relating to the transaction should be considered in making this allocation. [IFRIC 19.8]. Any consideration so allocated forms 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 modification should be accounted for as an extinguishment of the original liability and the recognition of a new liability in accordance with IFRS 9 (see Chapter 52 at 6.2). [IFRIC 19.10].

7.3 Debt for equity swaps with shareholders

As noted at 7.1 above, a debt for equity swap is outside the scope of IFRIC 19 when the creditor is a shareholder acting in its capacity as such, or where the entity and the creditor are under common control and the substance of the transaction includes a distribution by, or capital contribution to, the entity.

In our view, such transactions may be accounted for either in a manner similar to that required by IFRIC 19 or by recording the equity instruments issued at the carrying amount of the financial liability extinguished so that no profit or loss is recognised. This latter method was in fact commonly applied to debt for equity swaps before the publication of IFRIC 19.

8.1 Transaction costs of equity transactions

An entity typically incurs various costs in issuing or acquiring its own equity instruments, such as 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, but only to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. The costs of an equity transaction that is abandoned are recognised as an expense. [IAS 32.37].

Although IAS 32 does not provide a definition of directly attributable incremental costs, IFRS 9 does define an incremental cost as ‘one that would not have been incurred if the entity had not acquired, issued or disposed of the financial instrument.’ [IFRS 9 Appendix A]. IFRS 9 also gives as examples of costs which do meet this criterion: fees and commission paid to agents, advisors, brokers and dealers, levies by regulatory agencies and security exchanges, and transfer taxes and duties. [IFRS 9.B5.4.8]. Such costs together with other directly related costs such as underwriting and printing costs are usually considered to be incremental and directly attributable to the issue of equity. Internal administrative or holding costs e.g. costs which would have been incurred in any case if the equity instrument had not been issued, are not considered to be incremental or directly attributable.

IAS 32 requires that only the costs of ‘issuing or acquiring’ equity are recognised in equity. Accordingly, it seems clear that the costs of listing shares already in issue should not be set off against equity, but recognised as an expense.

The standard also requires that transaction costs that relate jointly to more than one transaction (for example, costs of a concurrent offering of some shares and a stock exchange listing of other shares) are allocated to those transactions using a basis of allocation that is rational and consistent with similar transactions. [IAS 32.38]. In its agenda decision of September 2008, the Interpretations Committee declined to provide further guidance on the extent of the transaction costs to be accounted for as a deduction from equity and how to allocate costs that relate jointly to more than one transaction, believing existing guidance to be adequate.

The Interpretations Committee noted that only incremental costs directly attributable to issuing new equity instruments or acquiring previously issued equity instruments are considered to be related to an equity transaction under IAS 32, but that the terms ‘incremental’ and ‘directly attributable’ are used with similar but not identical meanings in many Standards and Interpretations, leading to diversity in practice. It therefore recommended that the IASB develop common definitions for both terms to be added to the Glossary as part of the annual improvements process.³³ However, the IASB did not propose any such amendments in the next exposure draft published in August 2009.

It may well be that, in an initial public offering (‘IPO’), for example, an entity simultaneously lists its existing equity and additional newly-issued equity. In that situation the total costs of the IPO should, in our view, be allocated between the newly issued shares and the existing shares on a rational basis (e.g. by reference to the ratio of the number of new shares to the number of total shares), with only the proportion relating to the issue of new shares being deducted from equity.

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 (see Example 47.4 at 6.2 above). [IAS 32.38].

IAS 32 does not specifically address the treatment of transaction costs incurred to acquire a non-controlling interest in a subsidiary, or dispose of such an interest without loss of control in the consolidated financial statements of the parent entity. IFRS 10 indicates that ‘changes in a parent’s ownership interest in a subsidiary that do not result in the parent losing control of the subsidiary are equity transactions'. [IFRS 10.23]. Accordingly, we believe that the costs of such transactions should be deducted from equity in accordance with the principles described above.

IAS 32 and IFRS 10 do not specify whether such costs should be allocated to the parent's equity or to the non-controlling interest, to the extent it is still reflected in the statement of financial position. In our view, this is a matter of choice based on the facts and circumstances surrounding the transaction, and any local legal requirements. On any subsequent disposal of the subsidiary involving loss of control, the transaction costs previously recognised in equity should not be reclassified from equity to profit or loss, since they represent transactions with owners in their capacity as owners rather than components of other comprehensive income. [IAS 1.106, 109].

The amount of transaction costs accounted for as a deduction from equity in the period is required to be disclosed separately under IAS 1 (see Chapter 3 at 3.3) and IFRS 7 (see Chapter 54 at 7.3).

8.2 Tax effects of equity transactions

As originally issued, IAS 32 required distributions to shareholders and transaction costs of equity instruments to be shown net of any tax benefit. Annual Improvements to IFRSs 2009‑2011 Cycle issued in May 2012 amended IAS 32 so as to remove the reference to income tax benefit from IAS 32. This means that all tax effects of equity transactions are allocated in accordance with the general principles of IAS 12. [IAS 32.35A].

Unfortunately, it is not entirely clear how IAS 12 requires the tax effects of certain equity transactions to be dealt with and different views can be taken whether tax benefits in respect of distributions are to be recognised in equity or profit or loss (see Chapter 33 at 10.3.5).

9.1 Transactions in own shares not at fair value

The requirement of IAS 32 that no profits or losses should ever be recognised on transactions in own equity instruments differs from the approach taken in IFRS 2. If an employee share award is characterised as an equity instrument under IFRS 2 (a ‘share-settled’ award) and settled in cash (or other assets) at more than its fair value, the excess of the consideration over the fair value is recognised as an expense (see Chapter 34).

It is not clear whether or not the IASB specifically considered transactions in own equity other than at fair value in the context of IAS 32, particularly since the relevant provisions of IAS 32 essentially reproduce requirements previously contained in SIC‑16 – Share Capital – Reacquired Own Equity Instruments (Treasury Shares) – which was implicitly addressing market purchases and sales at fair value. In other words, the provision can be seen merely as clarifying that, if an entity buys one of its own shares in the market for £10 which it later reissues in the market at £12 or £7, it has not made, respectively, a profit of £2 or a loss of £3.

This is slightly different to the situation where an entity purchases an equity instrument for more than its fair value – i.e. if the original purchase had been for £11 when the market price was £10. Such a transaction could occur, for example where the entity wishes to rid itself of a troublesome shareholder or group of shareholders. In this case, the entity might have to offer a premium specific to the holder over and above the ‘true’ fair value of the equity instruments concerned. However, in general, where an entity purchases an equity instrument for more than its fair value, this can be indicative that other consideration has been received by the entity. It should be noted that IFRS 2 is explicit that any excess of the consideration over the fair value of an equity instrument is recognised as an expense. [IFRS 2.28(b)].

A transaction in which the entity issues shares (or reissues treasury shares) for cash or other assets with a fair value lower than the fair value of the shares would prima facie fall within the scope of IFRS 2, requiring the shortfall to be accounted for under IFRS 2 (see Chapter 34 at 2.2.2.C).

9.2 IFRS 17 treasury share election

An entity applying IFRS 17 – Insurance Contracts – may elect not to deduct a treasury share from equity, when it either:

• operates an investment fund that provides investors with benefits determined by units in the fund and recognises the amounts to be paid to those investors as financial liabilities; or
• issues groups of insurance contracts with direct participation features while holding the underlying items.

Where an entity reacquires its own equity to hold in an investment fund or as an underlying item in the above arrangements, it may elect to continue to account for the treasury share as equity with the reacquired instrument being accounted as if it were a financial asset measured through profit or loss in accordance with IFRS 9. The election is irrevocable and made on an instrument by instrument basis. [IAS 32.33A]. IFRS 17 is applicable for periods beginning on or after 1 January 2021 at the time of writing but can be early adopted by entities who have already adopted IFRS 9 and IFRS 15 – Revenue from Contracts with Customers.

11.1 Forward contracts

11.2 Call options

11.3 Put options