financial liability. Rather, the entity must consider all of the terms and conditions of the
financial instrument in determining its classification as a financial liability or equity.
Those terms and conditions include relevant local laws, regulations and the entity’s
governing charter in effect at the date of classification, but not expected future
amendments to those laws, regulations or charter. [IFRIC 2.5].
Accordingly, IFRIC 2 provides that an instrument, that would be classified as equity if
the holder did not have the right to request redemption, should be classified as an equity
instrument where:
• the entity has the unconditional right to refuse redemption;
• local law, regulation or the entity’s governing charter imposes an unconditional
prohibition on redemption; or
• the members’ shares meet the criteria in 4.6.2 or 4.6.3 above for classification as
equity. [IFRIC 2.6-8].
IFRIC 2 distinguishes between those prohibitions on redemption in local law, regulation
or the entity’s governing charter that are ‘unconditional’ (i.e. they apply at any time) and
those which prohibit redemption only when certain conditions – such as liquidity
constraints – are met or not met. Prohibitions that apply only in certain circumstances
are ignored and therefore would not result in equity classification. [IFRIC 2.8]. This is
consistent with the fact that under IAS 32 the classification of an instrument as debt or
equity is not influenced by considerations of liquidity (see 4.2 above).
In some cases, there may be a partial prohibition on redemption. For example,
redemption may be prohibited where its effect would be to reduce the number of
members’ shares or the amount of paid-in capital below a certain minimum. In such cases,
only the amount subject to a prohibition on redemption is treated as equity, unless:
Financial instruments: Financial liabilities and equity 3521
• the entity has the unconditional right to refuse redemption as described above; or
• the members’ shares meet the criteria in 4.6.2 or 4.6.3 above for classification as equity.
If the minimum number of members’ shares or amount of paid-in capital changes, an
appropriate transfer is made between financial liabilities and equity. [IFRIC 2.9].
Any financial liability for the redemption of instruments not classified as equity is
measured at fair value. In the case of members’ shares with a redemption feature, the
entity measures the fair value of the financial liability for redemption at no less than the
maximum amount payable under the redemption provisions of its governing charter or
applicable law, discounted from the first date that the amount could be required to be
paid. [IFRIC 2.10].
In accordance with the general provisions of IAS 32 regarding interest and dividends
(see 8 below), distributions to holders of equity instruments are recognised directly in
equity, net of any income tax benefits. Interest, dividends and other returns relating to
financial instruments classified as financial liabilities are expenses, regardless of
whether those amounts paid are legally characterised as dividends, interest or
otherwise. [IFRIC 2.11].
IFRIC 2 clarifies that, where members act as customers of the entity (for example, where
it is a bank and members have current or deposit accounts or similar contracts with the
bank), such accounts and contracts are financial liabilities of the entity. [IFRIC 2.6].
It should be noted that in the FICE DP (see 12 below), the IASB noted that the IFRS
requirements to account for financial instruments have been designed around the
concept of a contract. They further noted that IFRIC 2 was developed for a very specific
fact pattern and that they did not believe that the analysis in IFRIC 2 should be applied
more broadly.18
4.7 Perpetual
debt
‘Perpetual debt’ instruments are those that provide the holder with the contractual
right to receive payments on account of interest at fixed dates extending into the
indefinite future, either with no right to receive a return of principal or a right to a
return of principal under terms that make it very unlikely or very far in the future.
However, this does not mean that ‘perpetual debt’ is to be classified as equity, since
the issue proceeds will typically represent the net present value of the liability for
interest payments.
For example, an entity may issue a financial instrument requiring it to make annual
payments in perpetuity equal to a stated interest rate of 8% applied to a stated par or
principal amount of €1 million. Assuming 8% to be the market rate of interest for the
instrument when issued, the issuer assumes a contractual obligation to make a stream
of future interest payments having a fair value (present value) of €1 million. Thus
perpetual debt gives rise to a financial liability of the issuer. [IAS 32.AG6].
3522 Chapter 43
4.8
Differences of classification between consolidated and single
entity financial statements
4.8.1
Consolidated financial statements
In consolidated financial statements, IAS 32 requires an entity to present non-
controlling interests (i.e. the interests of other parties in the equity and income of its
subsidiaries) within equity, in accordance with IAS 1 – Presentation of Financial
Statements (see Chapter 3 at 3.1.5) and IFRS 10 – Consolidated Financial Statements
(see Chapter 7 at 4 and Chapter 9 at 8). [IAS 32.AG29].
When classifying a financial instrument (or a component of it) in consolidated financial
statements, an entity must consider all the terms and conditions agreed between all
members of the group and the holders of the instrument in determining whether the
group as a whole has an obligation to deliver cash or another financial asset in respect
of the instrument or to settle it in a manner that results in its classification as a financial
liability. [IAS 32.AG29].
For example, a subsidiary in a group may issue a financial instrument and a parent or
other group entity may then agree additional terms directly with the holders of the
instrument so as to guarantee some or all of the payments to be made under the
instrument. The effect of this is that the subsidiary may have discretion over
distributions or redemption, but the group as a whole does not. [IAS 32.AG29].
Accordingly, the subsidiary may appropriately classify the instrument without regard to
these additional terms in its individual financial statements. For the purposes of the
consolidated financial statements, however, the effect of the other agreements between
members of the group and the holders of the instrument is to create an obligation or
settlement provision, so that the instrument (or the component of it that is subject to the
obligation) is classified as a financial liability. [IAS 32.AG29].
Thus it is quite possible for a financial instrument to be classified as an equity instrument
in the financial statements of the issuing subsidiary but as a financial liability in the
financial statements of the group.
4.8.2
Single entity financial statements
The converse of the discussion in 4.8.1 above is that it is not uncommon
for instruments
that are classified as equity in the consolidated financial statements to give rise to
liabilities and embedded derivatives in the financial statements of individual members
of the group.
This is because a group wishing to raise finance for its operations will generally do so
through a group entity specialising in finance-raising, which will then on-lend the
proceeds of the finance raised to the relevant operating subsidiaries. The terms of the
intragroup on-lending transactions will often be such that finance which constitutes
equity from the perspective of group as a whole may be a liability in the individual
financial statements of the finance-raising entity itself.
For example, the finance-raising entity might issue an irredeemable instrument with a
‘dividend blocker’ clause (see 4.5.3.A above), under the terms of which that entity is not
required to make any payments to the holder unless the ultimate parent entity of the
Financial instruments: Financial liabilities and equity 3523
group pays a dividend to ordinary shareholders. Absent any other terms requiring its
classification, in whole or in part, as a liability under IAS 32, the instrument will be
treated as equity in the consolidated financial statements, since payments under the
instrument are contingent on an event within the control of the group (payment of a
dividend by the parent entity). In the finance-raising entity’s single entity financial
statements, however, the instrument should be classified as a liability, because the
subsidiary cannot control the dividend policy of its parent and could therefore be forced
to make payments to the holder of the instrument as a consequence of its parent entity
paying a dividend.
Another common example is that a group may issue a convertible bond which is actually
structured as a series of transactions along the following lines:
• a finance-raising subsidiary issues a bond, giving the holder a right to receive fixed,
non-discretionary interest payments, which converts into preference shares of that
subsidiary; and
• at the time that this conversion occurs, the parent entity is required to acquire the
preference shares of the subsidiary from the holder (i.e. the previous bondholder)
in exchange for equity of the parent.
Absent any other terms requiring classification as a liability under IAS 32, the instrument
will be treated as a compound instrument, consisting of a liability and an equity
component (see 6 below) in the consolidated financial statements. The instrument as a
whole might be classified as a liability in the subsidiaries financial statements, if (for
example) the preference shares issued on conversion by the subsidiary have terms that
require them to be classified as a liability by IAS 32. In that case, the subsidiary will have
issued an instrument that the holder can exchange either for cash or for a debt instrument.
From the subsidiary’s perspective, therefore, there is no equity component to the
instrument and the overall instrument would be classified as a liability that, under the
general rules of IFRS 9, must be recorded at fair value on initial recognition, which will
typically be lower than the proceeds received. This is because the pricing of the
instrument as a whole considers the conversion option that the holder receives, so that
the interest is typically paid at a rate below the rate that would apply to a liability
without a conversion option. In other words, the holder of the instrument ‘pays’ for the
conversion option through a reduced entitlement to interest.
The group accounts reflect the difference between the proceeds of issue and the fair
value of the liability component as the equity component (see 6 below). In the financial
statements of the issuing subsidiary, the most appropriate accounting treatment, in our
view, would be to treat this difference as an equity contribution by the parent, reflecting
the fact that the subsidiary can borrow on a reduced interest basis due to the conversion
option issued by the parent. Moreover, in the period prior to conversion, the parent is
required to account for its contingent forward contract to acquire the preference shares
in the finance company.
4.9
Reclassification of instruments
It happens from time to time that the terms of a financial instrument are modified in
such a way that an instrument that was an equity instrument at the original date of issue
3524 Chapter 43
would be classified as a financial liability if issued at the date of modification, or
vice versa. Alternatively, the terms of the instrument may remain unaltered, but external
circumstances may change. For example;
• an instrument might have been issued subject to a contingent settlement provision
(see 4.3 above) that, at the date of issue, was within the control of the issuer, but
ceases to be so at a later date,
• an instrument might have been issued subject to a contingent settlement provision
(see 4.3 above) that, at the date of issue, was not considered genuine, but becomes
so at a later date, or
• an instrument might have been issued requiring interest payments to be made
when contractually mandatory interest payments are made on another instrument
issued by the entity, the ‘linked’ instrument (see 4.5.7 above), but this linked
instrument is later repaid by the entity.
Such situations raise the question of whether such changes of terms or circumstances
should lead to reclassification of the instruments affected in the financial statements
and, if so, how the reclassification should be accounted for.
4.9.1
Change of terms
IAS 32 gives no guidance as to whether reclassification is required, permitted or
prohibited. The requirement of IAS 32 paragraph 15 that an instrument be classified ‘on
initial recognition’ (see 4 above) could be read as implying that classification occurs only
on initial recognition and is not subsequently revisited.
However, we do not consider this an appropriate analysis. A change in the terms of an
instrument is equivalent to the issue of a new instrument in settlement of the original
instrument. Such an exchange transaction would be accounted for by derecognising the
settled instrument and recognising (and classifying as a financial liability or equity) the
new replacement instrument. This analysis has been confirmed by an agenda decision
of the Interpretations Committee (see 4.9.1.A below). In our view, it would be
inappropriate to apply a different accounting treatment to a change in the terms of the
original instrument which has the same economic result.
4.9.1.A Equity
instrument to financial liability
At its meeting in November 2006, the Interpretations Committee considered a situation
in which an amendment to the contractual terms of an equity instrument resulted in the
instrument being classified as a financial liability. Two issues were discussed:
• the measurement of the financial liability at the date of the amendment to the
terms; and
• the treatment of any difference between the carrying amount of the previously
recognised equity instrument and the amount of the financial liability recogni
sed.
The Interpretations Committee decided not to add this issue to its agenda because, in
its view, the accounting treatment is clear. The financial liability is initially recognised
at fair value under the general provisions of IFRS 9 (see Chapter 45 at 3). Any difference
between the carrying amount of the liability and that of the previously recognised equity
instrument is recognised in equity in accordance with the general principle of IAS 32
Financial instruments: Financial liabilities and equity 3525
(see 8 below) that no gain or loss is recognised in profit or loss on the purchase, sale,
issue or cancellation of an entity’s own equity instruments.19
4.9.1.B Financial
liability to equity instrument
In the converse situation where the terms of a financial liability are changed such that
the instrument then meets the definition of an equity instrument, we believe, as above,
that the instrument should be reclassified to equity. That situation is analogous to a
debt-for-equity swap as discussed at 7 below and, therefore, should be accounted for in
accordance with IFRIC 19, where that interpretation applies. The most likely situation
in which IFRIC 19 would not apply would be in a transaction with shareholders in their
capacity as shareholders, as discussed at 7.3 below.
4.9.2
Change of circumstances
The nature and risk profile of a financial instrument may change as a result of a change
in circumstances. Such a change may occur simply as the result of the passage of time.
For example, in 2017 an entity might issue a bond mandatorily convertible at the end
of 2020. The conversion terms are that the holder will receive a number of the issuer’s
equity shares, being the lower of 100 shares or a number of shares determined according
to a formula based on the share price at 31 December 2017.
At the date of issue, this instrument is a financial liability since it involves an obligation
to deliver a variable number of equity instruments. At 31 December 2017, however,
the number of shares to be delivered on conversion can be determined and becomes
fixed. Accordingly, if considered as at 31 December 2017 and later, the instrument is
an equity instrument (absent any other terms requiring its continued classification as
financial liability).
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 696