IAS 32 Financial Instruments: Presentation — Summary, Worked Example & Practice Questions

Three standards share the work on financial instruments, and confusing them is the most common source of lost marks. IAS 32 handles presentation: how an issued instrument is classified between liabilities and equity, when a single instrument has to be broken into pieces, and when two balances may be shown as one net number (IAS 32.2). It is concerned with the face of the statements.

IFRS 9 picks up once the label is fixed. It decides when an instrument goes on and comes off the balance sheet, how it is measured on day one and afterwards, how expected credit losses are built up, and how hedge relationships work. IFRS 7 then handles the notes — the qualitative and quantitative disclosure of the risks an entity is running through its instruments.

A useful sequence to hold in mind: IAS 32 tells you which caption the instrument belongs under, IFRS 9 tells you what number goes there and how it moves, IFRS 7 tells you what to explain about it. The convertible bond later on this page runs through all three — IAS 32 splits it, IFRS 9 unwinds the liability at the market rate, IFRS 7 requires the reader to be told about the resulting exposures.

Note also that classification under IAS 32 is normally settled once, at the point the instrument is issued, and is not revisited simply because circumstances change afterwards (IAS 32.15). A liability does not become equity because the entity now expects never to be called on to pay.

Everything turns on whether the issuer has taken on a contractual obligation to hand over cash or another financial asset, or to exchange financial items on terms that could work against it (IAS 32.11). Where such an obligation exists and the entity cannot sidestep it, the instrument is a liability. Where no such obligation exists — where any payment is genuinely at the entity's discretion — the instrument represents a residual interest in the business and is presented within equity (IAS 32.16).

Two features of the test deserve emphasis. First, it looks at the issuer's position, not the holder's. Second, it is a test of economic substance, and legal labels carry no weight (IAS 32.15). An instrument described throughout its prospectus as a share can still be a borrowing, and an instrument called a bond can, in unusual cases, sit in equity.

• Redeemable preference shares with a fixed maturity date — the issuer must eventually pay the holder, so despite the name these are debt (IAS 32.18(a)). Any preference dividend on them is presented as interest expense.
• Preference shares redeemable only if the issuer chooses, carrying dividends the issuer may pass over — no unavoidable outflow exists, so this is equity.
• An instrument the holder can put back to the issuer for cash at any time — the decision belongs to the holder, so the entity cannot avoid settlement and a liability arises (IAS 32.18(b)), subject to a narrow exception for certain puttable instruments that behave like ordinary ownership (IAS 32.16A–16D).
• A perpetual note with no repayment date but compulsory annual coupons — the principal never has to be repaid, yet the coupon stream itself is an unavoidable series of payments, so a liability is recognised for the present value of those coupons.

Economic pressure is not the same as a contractual obligation. If an entity would suffer commercially by not paying a discretionary dividend, that reputational cost does not create a liability; only a term in the contract can. Conversely, a term that appears to give the entity a choice but where every available outcome ends in delivering cash gives the entity no real choice at all, and the instrument is a liability (IAS 32.20).

Settling in shares rather than cash does not automatically produce equity. The question is whether the number of shares to be delivered, and the consideration to be received for them, are both pinned down at the outset. Where they are, the counterparty is exposed to the entity's share price in the same way an owner is, and the contract is equity. Where either side of the exchange floats, the contract is a liability (IAS 32.16(b), 32.21–24).

The point is easiest to see with two contrasting written options. An option to subscribe for 100,000 shares at $5 each is equity: whatever happens to the share price, the entity delivers 100,000 shares and receives $500,000. An obligation to deliver however many shares are needed to make up a value of $500,000 is a liability, because the entity is really settling a fixed money amount and the shares are just the currency it happens to be using.

• Fixed number of shares for a fixed cash amount — equity; no remeasurement in later periods.
• Variable number of shares whose value equals a set sum — liability, remeasured through profit or loss.
• Fixed number of shares but a price linked to a commodity index or another variable — liability, since one leg is not fixed.
• A contract requiring the entity to buy back its own shares for cash — a liability for the present value of the redemption amount is recognised, even where the buy-back is conditional (IAS 32.23).

A limited relaxation applies to rights issues offered pro rata to all existing holders of a class of shares in a currency other than the entity's functional currency; these are treated as equity even though the exercise price is not fixed in functional currency terms (IAS 32.11, definition amended 2009).

Some instruments carry both characteristics in one contract. A convertible bond is the archetype: while it remains outstanding it obliges the issuer to pay coupons and, unless converted, to repay principal — a liability — but it also hands the holder the right to take shares instead, on fixed terms, which is an equity feature. IAS 32 requires the two elements to be presented separately from the moment of issue (IAS 32.28).

The split follows a strict order, and reversing it is the most frequent error. The liability is measured first, by discounting the contractual coupons and principal at the rate the market would demand for an otherwise identical instrument carrying no conversion right. Whatever remains of the issue proceeds after deducting that liability is the equity element (IAS 32.31–32). The equity component is never valued directly, and the two components always add back to the amount received.

• Step 1 — identify the market yield on comparable straight debt of the same issuer, term and seniority.
• Step 2 — present-value the coupon stream and the principal repayment at that yield; the total is the liability component.
• Step 3 — deduct the liability from the proceeds; the difference is credited to a separate component of equity.
• Step 4 — thereafter, unwind the liability at the market yield under IFRS 9, so the carrying amount climbs towards the redemption figure while the coupon paid stays at the contractual rate.

The equity component is fixed permanently at the amount first calculated. It is not remeasured as the share price moves, as the conversion becomes more or less likely, or as the maturity date approaches (IAS 32.30). On conversion the liability's carrying amount and the equity component are simply reclassified into share capital and share premium, and no gain or loss goes through profit or loss. If the bond runs to maturity without conversion, the equity component stays in equity — it may be transferred between reserves, but it is never recycled to profit or loss.

Because the coupon on a convertible is normally set below the straight-debt rate — investors accept less cash in exchange for the upside — the liability comes out below the proceeds, and the discount is exactly what gives the equity component its value. Where transaction costs are incurred, they are allocated across the two components in proportion to the split (IAS 32.38).

An entity cannot hold itself as an asset. Where its own shares are reacquired, the amount paid is deducted from equity, and no gain or loss is reported when those shares are later reissued or cancelled — any difference between the price paid and the price achieved on resale moves between reserves (IAS 32.33). This holds regardless of whether the shares are bought by the entity itself or by another member of the consolidated group.

The presentation of returns follows the classification of the instrument that produced them, which is the practical payoff of getting the debt-or-equity call right (IAS 32.35). Payments on something classified as a liability are a financing cost and reduce profit; payments on something classified as equity are a distribution and are taken directly to reserves, appearing in the statement of changes in equity rather than in profit or loss.

• Dividends on redeemable preference shares treated as debt — presented as interest expense in profit or loss, alongside interest on ordinary borrowings.
• Dividends on ordinary shares and on genuinely discretionary preference shares — charged against equity, never against profit.
• Costs of issuing new equity instruments — deducted from equity, net of any tax relief, rather than expensed (IAS 32.35, 37).
• Costs of issuing a liability — treated under IFRS 9 as part of the effective interest computation, so they are spread over the life of the borrowing.

A single hybrid can therefore produce both effects: on a convertible bond, the coupon and the additional unwinding of the discount are both interest expense, while the conversion option's carrying amount sits undisturbed in equity throughout.

Balances are presented gross unless two conditions are met together: the entity holds a right to set the amounts off that is enforceable as a matter of law at the reporting date, and it means in practice to settle the two amounts as a single net payment, or else to collect the asset and pay the obligation in one simultaneous movement (IAS 32.42). Both limbs are required — a right without an intention, or an intention without a right, leaves the balances presented separately.

The enforceability test is demanding. The right must survive not only ordinary trading but also the default or insolvency of either party, and it must operate across all counterparties concerned (IAS 32.45). A master agreement that only permits netting once a default has actually occurred does not qualify, because in normal circumstances the balances remain separately owing.

• A bank account in credit and a loan from the same bank — offset only where the arrangement legally permits netting and the entity means to use it; otherwise both appear in full.
• Trade receivable and trade payable with the same counterparty — offset only if a set-off right exists and net settlement is intended, not merely because it would be convenient.
• Derivatives cleared through the same exchange with simultaneous net cash movements — usually meet both tests.
• Positions netted only in a wind-up scenario — presented gross, because the condition is not satisfied in the ordinary course.

Offsetting is a presentation rule, not a shortcut for derecognition; where an asset has not actually been extinguished, showing it net would mislead a reader about the scale of the entity's exposures (IAS 32.43–44).