IAS 32 FINANCIAL INSTRUMENTS: PRESENTATION

1 THE TERM “FINANCIAL INSTRUMENT”

The term “financial instrument” used in IAS 32 as well as in other standards is defined in IAS 32. According to this definition, a financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or an equity instrument of another entity (IAS 32.11). The terms used in this definition are defined as follows:

• The term “entity” includes individuals, partnerships, incorporated bodies, government agencies, and trusts (IAS 32.14).
• An equity instrument (e.g. a share) is a contract that demonstrates a residual interest in the assets of an entity after deducting all of its liabilities (IAS 32.11).
• Financial assets include (among others) (IAS 32.11):
  • Cash.
  • Equity instruments of other entities held by the entity.
  • A contractual right to receive cash or another financial asset from another entity (i.e. certain receivables).
  • A contractual right to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity (this definition comprises financial derivatives with a positive fair value).
• Financial liabilities include (among others) (IAS 32.11):
  • A contractual obligation to deliver cash or another financial asset to another entity.
  • A contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity (this definition comprises financial derivatives with a negative fair value).
• Contracts within the scope of IAS 32 need not be in writing (IAS 32.13). Tax assets and tax liabilities are not contractual because they are created as a result of statutory requirements imposed by governments. Thus, they are not financial liabilities or financial assets. Income taxes are dealt with in IAS 12 (IAS 32.AG12).

The following examples illustrate the definitions above (IAS 32AG3–32.AG12):

• Examples of financial assets and financial liabilities:
  • Trade receivables and trade payables
  • Bonds from the holder's perspective (financial asset) as well as from the issuer's perspective (financial liability)
  • Loans from the holder's perspective (financial asset) as well as from the debtor's perspective (financial liability)
  • Financial guarantees from both the holder's and the issuer's perspective
  • Finance lease receivables and finance lease liabilities
  • Equity instruments of other entities, held by the entity
• Examples of non-financial assets and non-financial liabilities:
  • Inventories
  • Intangible assets
  • Property, plant, and equipment
  • Tax assets and tax liabilities
  • Constructive obligations within the meaning of IAS 37

2 SCOPE

The scope of IAS 32 does not include all financial instruments. For example, interests in subsidiaries, associates or joint ventures that are accounted for in accordance with IAS 27, IAS 28 or IAS 31 are outside the scope of IAS 32 (IAS 32.4–32.10).

3 DIFFERENTIATION BETWEEN EQUITY AND LIABILITIES

The issuer of a financial instrument has to classify the instrument or its component parts on initial recognition as a financial liability, a financial asset or an equity instrument (IAS 32.15).

Problems may occur in differentiating between equity and liabilities, in particular, in the case of mezzanine financing (e.g. contributions of capital that have equity characteristics in substance, but are debt from a legal perspective). Financing is generally regarded as equity if there is neither a conditional or unconditional contractual obligation to deliver cash or another financial asset, nor a contractual obligation to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity (IAS 32.16–32.20).

An example of an unconditional obligation to deliver cash is a preference share that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date. An example of a conditional obligation to deliver cash is a preference share that 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 (IAS 32.18a). In both cases the obligation to deliver cash leads to classification as a liability.

A compound financial instrument is a non-derivative financial instrument that contains both a liability and an equity component. Such components have to be classified separately as financial liabilities, financial assets or equity instruments according to IAS 32.15 (IAS 32.28). An important example of compound financial instruments comprises convertible bonds. The holder of a convertible bond has the right to convert the bond (liability) into shares (equity). This means that the holder can choose between redemption of the bond and receiving shares of the debtor.

The issuer of a compound financial instrument has to measure the equity component and the liability component based on the residual value method. According to this method the issuer of a convertible bond first determines the carrying amount of the liability component by discounting the future interest and redemption payments of the bond with the market interest rate for similar bonds having no conversion rights. The carrying amount of the equity component (conversion right) is then determined by deducting the carrying amount of the liability component from the proceeds of the bond issue (IAS 32.31–32.32) (under the presumption that there are no transaction costs).

The application of the classification rules of IAS 32, which are generally based on the existence of a (conditional or unconditional) contractual obligation to deliver cash or another financial asset, sometimes leads to inadequate results. For example, the capital contribution of a member in a partnership has to be classified as a liability if the member has the right to withdraw the investment and to receive cash from the entity as compensation for the investment in the case of withdrawal.

Thus, the IASB has introduced exceptional rules in order to solve this problem. However, these exceptional rules are not applicable when classifying non-controlling interests in the consolidated financial statements. Therefore, instruments classified as equity instruments in accordance with these special rules in the separate financial statements that are non-controlling interests are classified as liabilities in the consolidated financial statements of the group (IAS 32.AG29A and 32.BC68).

Another problematic topic comprises perpetual bonds. In many cases, the issuer of a perpetual bond has the right to redeem the bond at any time, whereas the holder of the perpetual bond cannot demand redemption. After several years the issuer may have no other economically rational choice than redeeming the bond due to accelerating interest payments. Consequently, it is clear that the bond will be redeemed in the future. Nevertheless, such contracts may be prepared in a way that leads to classification as equity under IAS 32 because the holder of the bond does not have the contractual right to demand redemption of the bond.1 This classification is more form-based than substance-based.

4 ACCOUNTING FOR A CONVERTIBLE BOND AFTER RECOGNITION BY THE ISSUER

After recognition, the liability component of a convertible bond is accounted for either at amortized cost (i.e. according to the effective interest method) or at fair value through profit or loss, depending on the circumstances.2 However, the carrying amount of the equity component is not affected by changes in fair value of the conversion feature after recognition (IAS 32.36 last sentence and IAS 39.2d). If the holder of a convertible bond chooses to receive shares of the debtor, he is waiving his receivable. The waiving of the receivable constitutes a contribution in kind in the issuer's statement of financial position (the entry is “Dr Liability Cr Share capital Cr Premium (equity)”). At the end of the term of the convertible bond, the original equity component remains as equity, although it may be transferred from one line item within equity to another (without affecting profit or loss or other comprehensive income), irrespective of whether the conversion right is exercised (IAS 32.AG32 and IAS 1.7).

5 TREASURY SHARES

If an entity reacquires its own equity instruments, these instruments (treasury shares) are deducted from equity. No financial asset is recognized for these instruments. This procedure corresponds with the view that a reacquisition of own equity instruments has the same effects as a reduction in capital. A purchase, sale, issue or cancellation of an entity's own equity instruments neither affects profit or loss, nor other comprehensive income (IAS 32.33, 32.AG36, and IAS 1.7).

With regard to presentation, the following procedures are generally regarded as being acceptable when an entity reacquires and subsequently sells its own equity instruments:3

• The consideration paid is presented as a one-line adjustment of equity (i.e. as a separate item of equity with a negative amount). When the treasury shares are sold at a later date, a credit entry is made for that item. If the consideration paid for acquiring the instruments differs from the consideration received when selling the instruments, the separate item of equity remains in the entity's financial statements with a positive or negative amount.
• The par value of the entity's own equity instruments reduces share capital, whereas the difference between par value and the higher consideration paid for the instruments reduces share premium (par value method). When the treasury shares are sold at a later date, the par value of the instruments increases share capital and the difference between par value and the higher consideration received for the instruments increases share premium. A positive or negative difference between the consideration paid for acquiring the instruments and the consideration received for selling them remains within the share premium.

6 COSTS OF AN EQUITY TRANSACTION

An example of an equity transaction is an increase in capital due to a contribution in cash. The par value of the shares issued increases share capital and the difference between par value and the higher consideration received for the shares increases share premium.

Costs of an equity transaction are deducted from equity, net of any related income tax benefit. This affects neither profit or loss nor other comprehensive income (IAS 32.35, 32.35A, and 32.BC33B). Assuming the costs of an equity transaction, which are deductible for tax purposes, are CU 100 and that the tax rate is 25%, equity is reduced by CU 75. The costs reduce cash by CU 100. The remaining amount of CU 25 represents a tax advantage. This is because the costs reduce taxable profit by CU 100, which leads to a reduction in income taxes payable by CU 25. Consequently, the tax advantage of CU 25 increases the current tax asset or reduces the current tax liability.

The procedure described above is implemented only to the extent that the costs are incremental costs directly attributable to the equity transaction that otherwise would have been avoided (IAS 32.37). By contrast, the costs that would have been incurred anyway are recognized in profit or loss. In practice this means that external costs (e.g. registration and other regulatory fees as well as amounts paid to legal advisers) are incremental costs. On the other hand, internal costs would have generally been incurred regardless and are therefore recognized in profit or loss. An exception is overtime, which is incurred due to the equity transaction and which is reimbursed separately. These are incremental costs and are therefore treated in the same way as external costs.

7 OFFSETTING

A financial asset and a financial liability have to be offset and the net amount presented in the statement of financial position when both of the following conditions are met (IAS 32.42):

• The entity currently has a legally enforceable right to set off the recognized amounts.
• The entity intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously.

8 EXAMPLES WITH SOLUTIONS

Example 2

Treasury shares

On Dec 31, 01, entity E acquires some of its own shares for CU 6 in order to offer its executive directors the possibility to purchase them the next year. The par value of these shares is CU 2. On Feb 14, 02, the shares are sold to the executive directors for (a) CU 7 and (b) CU 5.

Required

Prepare any necessary entries in E's financial statements as at Dec 31 for the years 01 and 02. Regarding the treasury shares, E (a) makes a one-line adjustment of equity and (b) applies the par value method.

Hints for solution

In particular Section 5.

Solution (a): One-line adjustment

Version (a)

Version (b)

The amounts (a) CU +1 and (b) CU –1 remain separate items of equity even though E does not hold these shares anymore.

Solution (b): Par value method

Version (a)

Version (b)

The amounts (a) CU +1 and (b) CU –1 remain in share premium even though E does not hold these shares anymore.

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Example 3

Costs of an equity transaction

In 01, entity E issues shares with a par value of CU 100 for CU 400.

In 01, an amount of CU 16 is paid regarding the issue to external advisers, banks, etc. This amount is deductible for tax purposes. Moreover, internal departments of E (e.g. accounting and finance) are involved with the issue:

• Further costs of CU 4 are incurred in 01 for overtime relating to the issue, which is reimbursed separately. These costs are deductible for tax purposes.
• Further costs of CU 10 are attributable to the equity transaction. However, these costs would have been incurred without the equity transaction. For simplicity reasons, it is presumed that these costs are not deductible for tax purposes.

Required

Prepare any necessary entries in E's financial statements as at Dec 31, 01. The tax rate is 25%.

Hints for solution

In particular Section 6.

Solution

The costs incurred for overtime relating to the issue which is reimbursed separately as well as the external costs (CU 4 + CU 16 = CU 20) are deducted from equity net of the related income tax benefit. The related income tax benefit is CU 5 (= CU 20 · 25%). The costs of CU 20 reduce taxable profit, which leads to a reduction in income taxes payable by CU 5. Thus, the tax advantage of CU 5 increases the current tax asset or reduces the current tax liability.

The entries above lead to the recognition of the economic benefit arising from the issue of shares of CU 385 (= CU 100 + CU 300 – CU 15) in share capital and share premium. This is correct because E receives CU 400 as a consideration for issuing the shares. Incremental costs directly attributable to the equity transaction of CU 20 are incurred and these costs give rise to a tax advantage of CU 5.

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Example 4

Convertible bond – separation on initial recognition

On Jan 01, 01, entity E issues a convertible bond (maturity: Jan 01, 01 until Dec 31, 01). The bond is issued at par with a face value of CU 100. Interest of 6% p.a. is payable on Dec 31, 01. The bond can be converted into five ordinary shares of E on Dec 31, 01. When the bond is issued, the prevailing market interest rate for similar debt without conversion rights is 9% p.a.

Required

Prepare any necessary entries in E's financial statements on initial recognition of the convertible bond.

Hints for solution

In particular Section 3.

Solution

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Example 5

Convertible bond – accounting treatment after recognition

Required

The facts are the same as in Example 4. Prepare the remaining entries that are necessary in E's financial statements as at Dec 31, 01. Assume that the liability component is measured at amortized cost (i.e. according to the effective interest method).4 Assume further that the creditor of the bond makes the following decision on Dec 31, 01:

(a) The creditor does not exercise his conversion right. Consequently, the bond is redeemed.

(b) The creditor exercises his conversion right. Thus, E issues shares. Par value of one of the five shares issued is CU 12.

Hints for solution

In particular Section 4.

Solution5

The recognition of the proceeds of the bond issue on initial recognition has already been illustrated in Example 4.

The carrying amount of the equity component is not affected by changes in fair value of the conversion feature after recognition (IAS 32.36 last sentence and IAS 39.2d).

According to the effective interest method, the carrying amount of the liability of CU 97.25 is increased to the redemption amount by applying the effective interest rate to the carrying amount as at Jan 01, 01 while taking into account the interest payment of 6%. The effective interest rate is 9% p.a. (see Example 4).

Version (a)

Since there is no conversion, the liability is redeemed on Dec 31, 01 at its par value:

The original equity component remains as equity although it may be transferred from one line item within equity to another (without affecting profit or loss or other comprehensive income) (IAS 32.AG32):

Version (b)

The holder of the convertible bond chooses to receive shares of E. This means that he waives his receivable. The waiving of the receivable constitutes a contribution in kind in E's statement of financial position.

The original equity component remains as equity, although it may be transferred from one line item within equity to another (without affecting profit or loss or other comprehensive income) (IAS 32.AG32):

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1 See IASB Update, June 2006, p. 4.

2 See the chapter on IFRS 9/IAS 39.

3 SIC 16, which contained examples with regard to the question of which item(s) of equity may be affected, has been withdrawn.

4 See the chapter on IFRS 9/IAS 39 (Section 2.3.5) regarding the effective interest method.

5 The solution would be the same if IFRS 9 and its consequential amendments were not applied early.