recognised net assets or the change in the fair value of the recognised and
unrecognised net assets of the entity (excluding any effects of such instrument
or contract); and
(ii) the effect of substantially restricting or fixing the residual return to the
instrument holders.
For the purposes of applying this condition, the entity should not consider non-
financial contracts with a holder of an instrument described in (a) to (c) above that
have contractual terms and conditions that are similar to the contractual terms and
conditions of an equivalent contract that might occur between a non-instrument
holder and the issuing entity. If the entity cannot determine that this condition is
met, it should not classify the instrument as an equity instrument. [IAS 32.16D].
Some of these criteria raise some issues of interpretation, which are addressed at 4.6.4 below.
Some of the criteria for classifying as equity financial instruments that entitle the holder
to a pro rata share of assets only on liquidation are similar to those (in 4.6.2 above) for
classifying certain puttable instruments as equity. The difference between these criteria
and those for puttable instruments are:
• there is no requirement for there to be no contractual obligations other than those
arising on liquidation;
• there is no requirement to consider the expected total cash flows throughout the
life of the instrument; and
• the only feature that must be identical among the instruments in the class is the
obligation for the issuing entity to deliver to the holder a pro rata share of its net
assets on liquidation.
The reason for the more relaxed criteria in this case is that the IASB took the view that,
given that the only obligation in this case arises on liquidation, there was no need to
consider obligations other than those on liquidation. However, the IASB notes that, if
3516 Chapter 43
an instrument does contain other obligations, these may need to be accounted for
separately under IAS 32. [IAS 32.BC67].
4.6.4
Clarification of the exemptions in 4.6.2 and 4.6.3 above
The conditions for treating certain types of puttable instruments (see 4.6.2 above) and
instruments repaying a pro rata share of net assets on liquidation (see 4.6.3 above) as
equity are complex. IAS 32 provides some clarification in respect of the following matters:
• instruments issued by a subsidiary (see 4.6.4.A below);
• determining the level of subordination of an instrument (see condition (b) under
4.6.2 and 4.6.3 above), (see 4.6.4.B below);
• the meaning of ‘no obligation to deliver cash or another financial asset’ (see
condition (d) under 4.6.2 above) in respect of instruments with a requirement to
distribute a minimum proportion of profit to shareholders (see 4.6.4.D below);
• other instruments that substantially fix or restrict the residual return to the holder
of an instrument (see condition (f)(ii) in 4.6.2 above and condition (d)(ii) in 4.6.3
above), (see 4.6.4.E below); and
• transactions entered into by an instrument holder other than as owner of the entity
(see 4.6.4.F below).
One matter on which IAS 32 does not provide further clarification is the meaning of
‘identical features’ (see condition (c) under 4.6.2 above). This is dealt with in 4.6.4.C below.
4.6.4.A Instruments
issued by a subsidiary
A subsidiary may issue an instrument that falls to be classified as equity in its separate
financial statements under one of the exceptions summarised in 4.6.2 and 4.6.3 above.
However, in the consolidated financial statements of the subsidiary’s parent such an
instrument is not recorded as a non-controlling interest, but as a financial liability.
[IAS 32.AG29A]. This reflects the fact that the exceptions in 4.6.2 and 4.6.3 above are both
subject to the condition that the instrument concerned is the most subordinated
instrument issued by the reporting entity. The IASB took the view that a non-controlling
interest, by its nature, can never be regarded as the residual ownership interest in the
consolidated financial statements. [IAS 32.BC68].
4.6.4.B Relative
subordination of the instrument
The exceptions in 4.6.2 and 4.6.3 above are both subject to the criterion – condition (b) –
that the instrument concerned is the most subordinated instrument issued by the reporting
entity. As noted at 4.6.1 above, this represents a departure from the normal principle of
IAS 32 that the classification of an issued instrument as a financial liability or equity should
be determined by reference only to the contractual terms of that instrument.
In order to determine whether an instrument is in the most subordinate class, the entity
calculates the instrument’s claim on a liquidation as at the date when it classifies the
instrument. The entity reassesses the classification if there is a change in relevant
circumstances (for example, if it issues or redeems another financial instrument).
[IAS 32.AG14B]. This is discussed further at 4.6.5 below.
Financial instruments: Financial liabilities and equity 3517
An instrument that has a preferential right on liquidation of the entity is not regarded as
an instrument with an entitlement to a pro rata share of the net assets of the entity. An
example might be an instrument that entitles the holder to a fixed dividend on
liquidation, in addition to a share of the entity’s net assets, when other instruments in
the subordinate class with a right to a pro rata share of the net assets of the entity do not
have the same right on liquidation. [IAS 32.AG14C].
If an entity has only one class of financial instruments, that class is treated as if it were
subordinate to all other classes. [IAS 32.AG14D].
In our view, the test of whether the instrument is the most subordinated has to be applied
according to the legal rights of the various classes of instrument, even where what is legally
the most subordinated instrument in issue is entitled to the return of only a nominal sum
on liquidation which may be dwarfed by the entitlement of other classes of shares.
It should be noted, however, that the requirement for a puttable instrument to be in the
most subordinate class of instruments issued by an entity does not preclude other, non-
puttable, instruments from being classified as equity at the same time. In an agenda
decision issued in March 2009, the Interpretations Committee noted that a financial
instrument is first classified as a liability or equity instrument in accordance with the
general requirements of IAS 32. That classification is not affected by the existence of
puttable instruments.17 Thus, for example, founders’ shares in an investment fund, which
are entitled only to the return of their par value on liquidation, would be classified as
equity even if less subordinate than a class of puttable shares which also qualify for
equity classification. Conversely, if the founders’ shares were the most subordinate
instruments, the puttable shares would have to be classified as liabilities.
4.6.4.C
Meaning of ‘identical features’
Condition (c) under 4.6.2 above requires that ‘all financial instruments in the class of
i
nstruments that is subordinate to all other classes of instruments have identical features.
For example, they must all be puttable, and the formula or other method used to
calculate the repurchase or redemption price is the same for all instruments in that
class’. The word ‘identical’ does not normally need much further explanation in the
English language. Nevertheless, some have questioned how literally the word must be
interpreted in this case.
Consider, for example, an investment fund that issues several types of puttable shares,
each equally subordinate, having identical redemption and dividend rights, but different
minimum subscription thresholds and subscription fees. Do all these instruments have
identical features for the purpose of this exemption? In our view the condition referred
to above is primarily designed to ensure that the redemption rights of the shares do not
differ. Accordingly, terms that take effect before the shares are issued (as in the example
above), or are not financial, should not cause instruments to fail the ‘identical features’
test. Examples of features which are not financial might include rights to information or
management powers. In our opinion, instruments with different features of this kind will
not necessarily fail the ‘identical features’ test, provided such features do not have the
potential to impact the redemption rights of the instruments.
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4.6.4.D
No obligation to deliver cash or another financial asset
One of the conditions for classifying a financial instrument as equity under 4.6.2 above is
that the instrument does not include any 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.
Some entities, particularly ones with limited lives, are required by their constitution to
distribute a minimum proportion of profits to shareholders or partners each year.
Subject to the matters discussed at 4.2 above, such a requirement will normally result in
the puttable instrument being considered a liability. It might be argued, firstly, that no
obligation arises in these circumstances until profits are made, and secondly that such
distributions only represent advance payments of the residual interest in the entity and
so are consistent with equity classification. However, the IASB discussed this issue while
developing the 2008 amendment and concluded that a contractual obligation existed,
the measurement of which was uncertain. Nevertheless, the IASB declined to provide
further guidance on this issue as they considered that it would have implications for
other projects.
In May 2010 the Interpretations Committee considered a request to clarify whether
puttable income trust units, that include contractual provisions to make distributions
on a pro-rata basis, can be classified as equity. The submission to the Interpretations
Committee argued that such pro-rata obligations should not prevent the instrument
from being classified as equity, by analogy to the Classification of Rights Issues
amendment to IAS 32 (October 2009). The Interpretations Committee decided not
to propose any amendment to IAS 32 to deal with this issue, making it fairly clear in
the process that they did not believe such an instrument would qualify to be classified
as equity.
4.6.4.E
Instruments that substantially fix or restrict the residual return to the
holder of an instrument
A condition for classifying a financial instrument as equity under 4.6.2 or 4.6.3 above is
that the issuing entity has no other financial instrument or contract that has:
• total cash flows based substantially on the profit or loss, the change in the
recognised net assets or the change in the fair value of the recognised and
unrecognised net assets of the entity; and
• the effect of substantially restricting or fixing the residual return.
IAS 32 notes that the following instruments, when entered into on normal commercial
terms with unrelated parties, are unlikely to prevent instruments that otherwise meet
the criteria in 4.6.2 or 4.6.3 above from being classified as equity:
• instruments with total cash flows substantially based on specific assets of the entity;
• instruments with total cash flows based on a percentage of revenue;
• contracts designed to reward individual employees for services rendered to the
entity; and
• contracts requiring the payment of an insignificant percentage of profit for services
rendered or goods provided. [IAS 32.AG14J].
Financial instruments: Financial liabilities and equity 3519
4.6.4.F
Transactions entered into by an instrument holder other than as owner
of the entity
IAS 32 observes that the holder of a financial instrument subject to one of the
exceptions in 4.6.2 or 4.6.3 above may enter into transactions with the entity in a role
other than that of an owner. For example, an instrument holder also may be an
employee of the entity. IAS 32 requires that only the cash flows and the contractual
terms and conditions of the instrument that relate to the instrument holder as an owner
of the entity be considered when assessing whether the instrument should be classified
as equity under conditions (a) to (e) in 4.6.2 above or conditions (a) to (c) in 4.6.3 above.
[IAS 32.AG14F].
An example might be a limited partnership that has limited and general partners. Some
general partners may provide a guarantee to the entity and be remunerated for
providing that guarantee. In such situations, the guarantee and the associated cash flows
relate to the instrument holders in their role as guarantors and not in their roles as
owners of the entity. Therefore, such a guarantee and the associated cash flows would
not result in the general partners being considered subordinate to the limited partners,
and would be disregarded when assessing whether the contractual terms of the limited
partnership instruments and the general partnership instruments are identical.
[IAS 32.AG14G].
Another example might be a profit or loss sharing arrangement that allocates profit or
loss to the instrument holders on the basis of services rendered or business generated
during the current and previous years. Such arrangements are regarded as transactions
with instrument holders in their role as non-owners and should not be considered when
assessing the criteria in conditions (a) to (e) in 4.6.2 above or conditions (a) to (c) in 4.6.3
above. By contrast, profit or loss sharing arrangements, that allocate profit or loss to
instrument holders based on the nominal amount of their instruments relative to others
in the class, represent transactions with the instrument holders in their roles as owners
and should be considered when assessing the criteria in conditions (a) to (e) in 4.6.2
above or conditions (a) to (c) in 4.6.3 above. [IAS 32.AG14H].
IAS 32 notes that, in order for a transaction with an owner to be assessed as being
undertaken in that person’s capacity as a non-owner, the cash flows and contractual terms
and conditions of the transaction must be similar to those of an equiv
alent transaction that
might occur between a non-instrument holder and the issuing entity. [IAS 32.AG14I].
4.6.5
Reclassification of puttable instruments and instruments imposing an
obligation only on liquidation
As noted in 4.6.4.B above, IAS 32 requires the entity to continually reassess the
classification of such an instrument. The entity classifies a financial instrument as an
equity instrument from the date on which it has all the features and meets the conditions
set out in 4.6.2 or 4.6.3 above, and reclassifies the instrument from the date on which it
ceases to have all those features or meet all those conditions.
For example, if an entity redeems all its issued non-puttable instruments, any puttable
instruments that remain outstanding and that have all of the features and meet all the
conditions in 4.6.2 above, are reclassified as equity instruments from the date of
redemption of the non-puttable instruments. [IAS 32.16E].
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Where an instrument, previously classified as an equity instrument, is reclassified as a
financial liability, the financial liability is measured at fair value at the date of reclassification,
with any difference between the carrying value of the equity instrument and the fair value
of the financial liability at the date of reclassification being recognised in equity. [IAS 32.16F(a)].
Where an instrument, previously classified as a financial liability, is reclassified as an
equity instrument, the equity instrument is measured at the carrying value of the
financial liability at the date of reclassification. [IAS 32.16F(b)].
4.6.6 IFRIC
2
The issue that ultimately led to the publication of IFRIC 2 was the appropriate
accounting treatment for the members’ contributed capital of a co-operative entity, the
members of which are entitled to ask for the return of their investment. However, the
scope of IFRIC 2 is not confined to co-operative entities, and extends to any entity
whose members may ask for a return of their capital. [IFRIC 2.1-4].
IFRIC 2 states that the contractual right of the holder of a financial instrument to request
redemption does not, in itself, require that financial instrument to be classified as a
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