IAS 32 financial instruments presentation – Financial instruments issued by a company must be classified as either liabilities or equity. These IAS 32 summary notes are prepared by mindmaplab team and covering the key definitions, equity instrument accounting, the relationship between IAS 32 and ifrs 9 with examples and IFRS 32 journal entries. This is the IAS 32 full text; we have also prepared IAS 32 pdf version download.
IAS 2 Inventories
IAS 7 Statement of cash flows – Revisited
IAS 33 Earnings per share – Revisited
Liability or Equity
Financial instruments issued by a company must be classified as either liabilities or equity.
A financial liability is any liability where the issuer has a contractual obligation:
- To deliver cash or another financial asset to another entity, or
- To exchange financial instruments with another entity on potentially unfavourable terms.
An equity instrument is defined as any contract that offers the residual interest in the assets of the company after deducting all of the liabilities. The owner of an equity instrument is entitled to receive a dividend.
Returns on financial instruments
Returns on financial instruments are reported differently, depending on whether the instrument is a liability or equity. This classification determines the treatment of the interest, dividends, gains and losses.
- Interest expense, dividend payments, gains and losses relating to a financial liability are recognised in the statement of profit or loss.
- Distributions to equity holders are debited to equity and shown in the statement of changes in equity.
Preference shares are shares that are entitled to a payment of their dividend, usually a fixed amount each year. Preference shares include the following types:
- Redeemable preference shares are those that the entity has an obligation to buy back (or the right to buy back) at a future date.
- Irredeemable (perpetual) preference shares are those that will not be bought back at any time in the future.
- Convertible preference shares are those that are convertible at a future date into another financial instrument, usually into ordinary equity shares of the entity.
Classification of preference shares
Preference shares issued by a company might be classified as:
- equity; or
- a financial liability of the company; or
- a compound financial instrument containing elements of both financial liability and equity.
Preference shares accounting treatment
Redeemable preference shares
- Redemption is mandatory: Since the issuing entity will be required to redeem the shares, there is an obligation. The shares are a financial liability.
- Redemption at the choice of the holder: Since the issuing entity does not have an unconditional right to avoid delivering cash or another financial asset there is an obligation. The shares are a financial liability.
- Redemption at the choice of the issuer: The issuing entity has an unconditional right to avoid delivering cash or another financial asset there is no obligation. The shares are equity.
Irredeemable non-cumulative preference
These shares should be treated as equity, because the entity has no obligation to the shareholders that the shareholders have any right to enforce.
A compound instrument is a financial instrument, issued by a company that cannot be classified as simply a liability or as equity, because it contains elements of both debt and equity. An example of a compound instrument is a convertible bond.
Split accounting for compound instruments
On initial recognition of compound instrument, the credit entry for the financial instrument must be split into the two component parts, equity and liability.
*The question is how to determine the amount of the issue price that is debt and the amount that is equity?
The method to use is to calculate the equity element as the residual after determining the present value of the debt element:
- Step I – The present value of the interest payments and the redemption value of the convertible is found using a market interest rate for similar debt finance which is not convertible
- Step II – Compare this present value to the proceeds of the bond issue to find the residual equity element.
Any transaction costs incurred by issuing the instrument should be allocated to each component, the liability and equity, according to the split.
The initial double entry to recognise the compound instrument would be as follows:
Cash (proceeds) Dr.(xxxx)
Equity Cr. (xx)
- Subsequently the liability component is measured at amortised cost.
- There is no guidance on the subsequent accounting treatment of the equity element. One approach would be to retain it as a separate component of equity and then release it to retained earnings when the bond is paid or converted.
Transactions in own equity
A company may reacquire its own shares. Such shares are called treasury shares. The entity might hold and used them for particular purposes such as awarding shares to employees in a share grant scheme. The accounting treatment of treasury shares is that they should be deducted from equity.
Any gain or loss on transactions involving treasury shares is recognised directly in equity, and should not be reported in the statement of profit or loss and other comprehensive income.
IAS 32 requires that the amount of treasury shares held should be disclosed separately, either:
- on the face of the statement of financial position as a deduction from share capital, or
- offset against share capital and disclosed in the notes to the accounts.
The IAS 32 rule is that a financial asset and a financial liability must be offset and shown net in the statement of financial position when and only when an entity:
- Currently has a legal right to set off the amounts; and
- Intends either to settle the amounts net, or to realise (sell) the asset and settle the liability simultaneously.
Dividends are payable only out of the distributable profits of the company (but not profit on the sale of capital assets).
Dividends are paid by individual entities. When a group announces that it is paying a dividend it is actually the parent company that is making the payment.
IFRIC 2: Members shares in cooperative entities and similar instruments
Co-operatives (and similar entities) are formed by groups of persons to meet common economic or social needs. Members’ interests in a co-operative are often described as “members’ shares”. Members’ shares have characteristics of equity.