Financial Repor ting Financial Instruments
Financial Instruments
Robert Kirk demystifies the presentational issues of IAS 32
ccounting for financial instruments has been one
A of the more complex of accounting issues to
resolve for standard setters. However, now both
local FRS (FRS 25) and international IFRS (IAS 32) agree
on how these instruments should be presented in the
financial statements. In addition, the expected IFRS for
Private Entities will include a similar section on the topic
in the forthcoming standard.
Objective of IAS 32
The objective of IAS 32 is to enhance users'
understanding of the significance of financial instruments
to an entity's financial position, performance, and cash
flows.
IAS 32 addresses this in a number of ways:
• Clarifying the classification of a financial instrument
issued by an enterprise as either a liability or as
equity or even a mixture of the two.
• Prescribing the accounting treatment for treasury
shares (a company's own repurchased shares).
• Prescribing strict conditions under which assets and
liabilities may be offset in the balance sheet.
Its sister standard IAS 39 ‘Financial Instruments:
Recognition and Measurement’ deals with, among other
things, the initial recognition of financial assets and
liabilities, the measurement subsequent to initial
recognition, impairment, derecognition, and hedge
accounting. These are not covered in this article nor are
the contents of the disclosure standard, IFRS 7 ‘Financial
instruments: disclosure’.
Scope
IAS 32 applies in presenting information about all
types of financial instruments with the following
exceptions:
• Interests in subsidiaries, associates, and joint ventures
that are accounted for under IAS 27 Consolidated
and Separate Financial Statements, IAS 28
Investments in Associates, or IAS 31 Interests in Joint
Ventures. However, IAS 32 applies to all derivatives
on interests in subsidiaries, associates, or joint
ventures.
• Employers' rights and obligations under employee
benefit plans (see IAS 19).
• Rights and obligations arising under insurance
contracts (see IFRS 4).
• Contracts for contingent consideration in a business
combination (see IFRS 3).
• Contracts that require a payment based on climatic,
geological or other physical variables (weather
derivatives) (see IAS 39).
Key Definitions
Financial instrument:
• A contract that gives rise to a financial asset of one
entity and a financial liability or equity instrument of
another entity.
Financial asset:
• Any asset that is:
- cash;
- an equity instrument of another entity;
- a contractual right:
▼ to receive cash or another financial asset from
another entity; or
▼ to exchange financial assets or financial
liabilities with another entity under conditions
that are potentially favourable to the entity; or
▼ a contract that will or may be settled in the
entity's own equity instruments and is:
- a non-derivative for which the entity is or
may be obliged to receive a variable number
of the entity's own equity instruments; or
- a derivative that will or may be settled other
than by the exchange of a fixed amount of
cash or
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 Financial Repor ting Financial Instruments
another financial asset for a fixed number of the entity's
own equity instruments. For this purpose the entity's
own equity instruments do not include instruments that
are themselves contracts for the future receipt or
delivery of the entity's own equity instruments.
Financial liability:
Any liability that is:
- a 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; or
▼ a contract that will or may be settled in the entity's
own equity instruments
Equity instrument:
Any contract that evidences a residual interest in the assets
of an entity after deducting all of its liabilities.
Example
A start up company is experiencing severe cash flow
problems. A supplier agrees to supply goods to the value of
€1,000 in return for the company issuing to it, in 60 days
time, shares that have a market value of €1,000. The
number of shares that the company must deliver under the
contract is variable – it will depend on the market value of
its shares at the settlement date.
This contract would be classified as a financial liability – it is
no different from a contract to pay €1,000 cash or to deliver
other assets worth €1,000 in exchange for the goods.
Fair value:
The amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an
arm's length transaction.
Classification as Liability or Equity
The fundamental principle of IAS 32 is that a financial
instrument should be classified as either a financial liability or
an equity instrument according to the substance of the contract,
not its legal form. The enterprise must make the decision at the
time the instrument is initially recognised. The classification
may not be subsequently changed based on changed
circumstances.
Effectively, this means that preference shares which are
redeemable must now be classified as liabilities, not as equity.
On the other hand, if the preference shares are non
redeemable their nature is more like equity. The dividends
attached to these instruments must be consistent with their
balance sheet treatment and thus dividends on redeemable
preference shares must be treated as finance costs and not
appropriations of income.
Compound Financial Instruments
Some financial instruments - sometimes called compound
instruments or hybrids - have both a liability and an equity
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component from the issuer's perspective. In that case, IAS 32
requires that the component parts be accounted for and
presented separately according to their substance based on the
definitions of liability and equity. The split is made at issuance
and not revised for subsequent changes in market interest
rates, share prices or other event that changes the likelihood
that the conversion option will be exercised.
To illustrate, a convertible bond contains two components.
One is a financial liability, namely the issuer's contractual
obligation to pay cash, and the other is an equity instrument,
namely the holder's option to convert into common shares.
Another example of a compound instrument would be debt
issued with detachable share purchase warrants.
When the initial carrying amount of a compound financial
instrument is required to be allocated to its equity and liability
components, the equity component is assigned the residual
amount after deducting from the fair value of the instrument as
a whole the amount separately determined for the liability
component.
Example – convertible loan
Facts:
A company issues a 3 year convertible bond at its par value of €1m
which carries interest at 5% per annum annually in arrears. Must
assume a market rate for a similar straight loan without conversion
rights, say 7%.
Solution:
Liability: Principal €1m discounted at 7% end of year 3
X 0.8163 = 816,299
Interest €50,000 for 3 years discounted at 7%
X 2.6243 = 131,214
947,513
Total net proceeds 1,000,000
Equity component 52,487
One company applying the split accounting required for
compound instruments is BAE Systems Plc:
BAE Systems Plc:
Preference Shares
The 7.75p (net) cumulative redeemable preference shares of 25p
each are convertible into ordinary shares of 2.5p each at the option
of the holder on 31 May in any of the years up to 2007, on the
basis of 0.47904 ordinary shares for every preference share. During
the year 187, 489 shares were converted for 89,814 ordinary
shares. The Group may redeem all of the remaining preference
shares at any time after 1 July 2007 and, in any case, will redeem
any remaining shares on 1 January 2010, in each case at 100p per
share together with any arrears and accruals of dividend. The
maximum redemption value of the preference shares, ignoring any
arrears or accruals of dividend, is therefore £266m.
As stated in note 1, the Group has adopted IAS 39 from 1 January
2005. In accordance with IAS 32 the convertible preference shares
are considered to be a compound financial instrument consisting of
both a debt element and an equity component which require
separate accounting treatment. Under IAS 32, the equity option
element of preference shares of £78m is included as a separate
component of equity. The debt component is recognised within
loans and overdrafts (note 20).

In the year that Irish listed companies adopted IAS 32 Glanbia
Plc explained how they have changed their presentation from
equity to liabilities. In addition, the cost of shares held by an
Employee Share Trust has been deducted from equity.
Glanbia Plc
(q) Share capital
(i) Preferred securities and preference shares
For 2004:
Preferred securities and preference shares, with fixed
dividend entitlements and fixed redemption dates,are
accounted for as non-equity minority instruments within
shareholders’ funds.
From 2005:
Such preferred securities and preference shares are
classified as liabilities.
(ii) Own Shares
The cost of own shares, held by and Employee Share Trust
in connection with the Company’s Sharesave Scheme, is
deducted from equity.
Treasury Shares
The cost of an entity's own equity instruments that it has
reacquired ('treasury shares') is deducted from equity. A gain or
loss is not recognised on the purchase, sale, issue, or cancellation
of treasury shares. Treasury shares may be acquired and held by
the entity or by other members of the consolidated group. Any
consideration paid or received is recognised directly in equity.
Offsetting
IAS 32 also prescribes rules for the offsetting of financial assets
and financial liabilities. It specifies that a financial asset and a
financial liability should be offset and the net amount reported
when, and only when, an enterprise:
• has a legally enforceable right to set off the amounts; and
• it intends either to settle on a net basis, or to realise the asset
and settle the liability simultaneously.
Example
Facts:
A manages its exposure to changes in copper prices and locks in
the cost of funding by entering into options. These included both
call and put options at various strike prices and various maturity
dates. These will be settled in cash and are thus derivatives. The
bank permits a legal right of set off on termination or on default but
not in the ordinary course of business.
Solution:
As only allowed to offset in the event of a contingent event e.g.
default or termination IAS 32 is not satisfied. Also, by having
different maturity dates, the company does not demonstrate an
intention to settle net simultaneously.
IFRS for Private Entities (due December 2008)
Section 11 of the exposure draft for the new IFRS is entitled
Financial Assets and Financial Liabilities and, at present, permits
companies to opt for full coverage of IAS32/39 or apply the IFRS
for Private Entities
Financial Repor ting Financial Instruments
The scope is identical to the full IAS 32 standard.
Initial recognition of financial assets and
liabilities
An entity may only recognise these when it becomes a party
to the contractual provisions of the instrument but the rules will
be exactly the same as the full IAS 32. For example, compound
financial instruments will still require to be separated between
their debt and equity components.
Amendment to FRS 12 (February 2008)
Puttable instruments and obligations arising
on liquidation
In February 2008, the IASB amended IAS 32 and IAS 1
Presentation of Financial Statements with respect to the balance
sheet classification of puttable financial instruments and
obligations arising only on liquidation. As a result of the
amendments, some financial instruments that currently meet the
definition of a financial liability will be classified as equity because
they represent the residual interest in the net assets of the entity.
The amendments have detailed criteria for identifying such
instruments, but they generally would include:
• Puttable instruments that are subordinate to all other classes
of instruments and that entitle the holder to a pro rata share
of the entity's net assets in the event of the entity's
liquidation. A puttable instrument is a financial instrument that
gives the holder the right to put the instrument back to the
issuer for cash or another financial asset or is automatically
put back to the issuer on the occurrence of an uncertain
future event or the death or retirement of the instrument
holder.
• Instruments, or components of instruments, that are
subordinate to all other classes of instruments and that
impose on the entity an obligation to deliver to another party
a pro rata share of the net assets of the entity only on
liquidation.
The amendments result from proposals that were in an
Exposure Draft published by the Board in June 2006. These
amendments are effective for annual periods beginning on or
after 1 January 2009 but earlier application is permitted.
Summary
Since both FRS 25 and IAS 32 have lost their disclosure
requirements the essence of the revised standards has been to
ensure that the various financial instruments reflect the substance
of their arrangements and not necessarily their legal form. Even
after introducing this principle the IASB has had to issue an
amendment to interpret whether puttable instruments should be
classified as equity or as liabilities. Inevitably there could be further
interpretations to come as financial instruments become
increasingly complex.
Robert Kirk is Professor of Financial Reporting at the University
of Ulster.
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