that are potentially unfavourable to the issuer. [IAS 32.17].
IAS 32 focuses on the contractual rights and obligations arising from the terms of an
instrument, rather than on the probability of those rights and obligations leading to an
outflow of cash or other resources from the entity, as would be the case for a provision
accounted for under IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
(see Chapter 27). Thus, IAS 32 may well:
• classify as equity: an instrument that is virtually certain to result in regular cash
payments by the entity; but
• treat as a liability: an instrument which:
• gives its holder a right to receive cash rather than equity which no rational
holder would exercise; or
• exposes the issuer to a liability to repay the instrument contingent on an
external event so remote that no liability would be recognised if IAS 37 rather
than IAS 32 were the applicable standard.
The holder of an equity instrument (e.g. a non-puttable share) is entitled to receive a
pro rata share of any dividends or other distributions of equity that are made. However,
since the issuer does not have a contractual obligation to make such distributions
(because it cannot be required to deliver cash or another financial asset to another
party), the instrument is not a financial liability of the issuer. [IAS 32.17]. The price or value
of such an instrument may well reflect a general expectation by market participants that
distributions will be made on a regular basis, but, under IAS 32, the absence of a
contractual obligation requires the instrument to be classified as equity.
IAS 32 requires the issuer of a financial instrument to classify a financial instrument by
reference to its substance rather than its legal form, although it is conceded that
substance and form are ‘commonly’, but not always, the same. Typical examples of
instruments that are equity in legal form but liabilities in substance are certain types of
preference share (see 4.5 below) and certain units in open-ended funds, unit trusts and
similar entities (see 4.6 below). [IAS 32.18]. Conversely, a number of entities have issued
instruments which behave in most practical respects as perpetual (or even redeemable)
debt, but which IAS 32 requires to be classified as equity (see 4.5 below). IAS 32 further
clarifies that a financial instrument is an equity instrument, and not a financial liability,
not merely if the issuer has no legal obligation to deliver cash or other financial assets
to the holder at the reporting date, but only if it has an unconditional right to avoid doing
so in all future circumstances other than an unforeseen liquidation. Thus, a financial
instrument (other than one classified as equity under the exceptions discussed at 4.6
below) is classified as a financial liability even if:
3496 Chapter 43
• the issuer’s ability to discharge its obligations under the instrument is restricted
(e.g. by a lack of funds, the need to obtain regulatory approval to make payments
on the instrument, or a shortfall of distributable profits, or other statutory
restriction); [IAS 32.19, AG25] or
• the holder has to perform some action (e.g. formally exercise a redemption right)
in order for the issuer to become obliged to transfer cash or other financial assets.
[IAS 32.19].
In September 2015 the Interpretations Committee considered the classification of a prepaid
card and how the unspent balance on such a card would be accounted for. The
Interpretations Committee specifically considered a prepaid card with the following features:
• no expiry date;
• cannot be refunded, redeemed or exchanged for cash;
• redeemable only for goods and services;
• redeemable only at selected merchants which could include the entity;
• upon redemption by the cardholder at a merchant, the entity has a contractual
obligation to pay cash to the merchant;
• no back-end fees, e.g. the balance on the prepaid card does not reduce unless spent
by the cardholder; and
• is not issued as part of a customer loyalty programme.
The Interpretations Committee observed that the liability of the entity for the prepaid
card meets the definition of a financial liability, because the entity has a contractual
obligation to deliver cash to the merchants on behalf of the cardholder, conditional upon
the cardholder using the prepaid card to buy goods or services and the entity does not
have an unconditional right to avoid delivering cash to settle this contractual obligation.3
Following the receipt of responses to the draft agenda decision, the Interpretations
Committee, in March 2016, limited the fact pattern to where the card could only be
redeemed at specified third-party merchants and not at the entity itself but otherwise
did not change its conclusion.
The Interpretations Committee determined that neither an interpretation nor an
amendment to a standard was necessary.4
One of the key consequences of this decision is that if the card gives rise to a financial
liability then the unspent balance on the card cannot be derecognised. Any unredeemed
portion of the card will continue to be recognised as a liability in perpetuity as financial
liabilities can only be derecognised when extinguished. [IFRS 9.3.3.1]. It is also of note that
the balances on such cards are regarded as financial liabilities even though they do not
meet the strict IAS 32 definition of a financial instrument, as the balance on the prepaid
card will not constitute a financial asset in the hands of the cardholder.
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
Financial instruments: Financial liabilities and equity 3497
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
&n
bsp; 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].
3498 Chapter 43
IAS 32.20 provides two examples:
(a) 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.
(b) A financial instrument is a financial liability if it provides that on settlement the
entity will deliver either:
i.
cash or another financial asset; or
ii.
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, IAS 32.20 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
Financial instruments: Financial liabilities and equity 3499
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
Contingent settlement provisions
Some financial instruments may require the entity to deliver cash or another financial
asset, or otherwise to settle it in such a way that it would be classified as a financial
liability, in the event of the occurrence or non-occurrence of uncertain future events
(or on the outcome of uncertain circumstances), that are beyond the control of both the
issuer and the holder of the instrument. These might include:
• a change in a stock market index or a consumer price index;
• changes in interest rates;
• changes in tax law; or
• the issuer’s future revenues, net income or debt-to-equity ratio. [IAS 32.25].
IAS 32 provides that, since the issuer of such an instrument does not have the
unconditional right to avoid delivering cash or another financial asset (or otherwise to
settle it in such a way that it would be a financial liability), the instrument is a financial
liability of the issuer unless:
• the part of the contingent settlement provision that co
uld require settlement in
cash or another financial asset (or otherwise in such a way that it would be a
financial liability) is not genuine (see 4.3.1 below);
• the issuer can be required to settle the obligation in cash or another financial asset
(or otherwise to settle it in such a way that it would be a financial liability) only in
the event of liquidation of the issuer (see 4.3.2 below); or
• the instrument is classified as equity under the exceptions discussed at 4.6 below.
[IAS 32.25].
Whether or not the contingency is within the control of the issuer is therefore an
important consideration when classifying financial instruments with contingent
settlement provisions as either financial liabilities or equity (see 4.3.4 below).
It is interesting that ‘future revenues, net income or debt-to-equity ratio’ are given as
examples of contingencies beyond the control of both the issuer and the holder of the
instrument, since, in some cases, these matters are within the control of the entity. For
example, if a payment under a financial instrument is contingent upon revenue rising
above a certain level, the entity could avoid the payment by ceasing to trade before
revenue reaches that level. Indeed, IAS 37 argues that certain expenses (such as legally
required maintenance costs) that an entity is certain to incur if it continues to trade are
not liabilities until they become legally due, because the entity could avoid them by
ceasing to trade by that date. As in 4.2.2 above, the analysis in IAS 32 appears to be
relying on the concept of ‘economic compulsion’ (i.e. the entity would not rationally
cease its activities merely in order to avoid making a contingent payment), even though
this does not feature in the definition of ‘contingent liability’ in IAS 37, or indeed in the
classification of many instruments under IAS 32.
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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].
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 691