Resources (This includes links to the latest standards, drafts, PwC interpretations, tools and practice aids for this topic)
The IASB has been working on a project to replace IAS 32 for a number of years. The ‘Financial instruments with characteristics of equity’ project (‘FICE’) is on the research agenda of the IASB and is being developed concurrently with the Conceptual Framework project. Any proposals could result in fundamental changes to the current model.
The classification of a financial instrument by the issuer as either a liability (debt) or equity can have a significant impact on an entity's gearing (debt-to-equity ratio) and reported earnings. It could also affect the entity's debt covenants.
The critical feature of a liability is that under the terms of the instrument, the issuer is or can be required to deliver either cash or another financial asset to the holder; it cannot avoid this obligation. For example, a debenture under which the issuer is required to make interest payments and redeem the debenture for cash is a financial liability.
An instrument is classified as equity when it represents a residual interest in the issuer's assets after deducting all its liabilities; or, put another way, when the issuer has no obligation under the terms of the instrument to deliver cash or other financial assets to another entity. Ordinary shares where all the payments are at the discretion of the issuer are examples of equity of the issuer.
In addition, the following types of financial instruments are accounted for as equity, provided they have particular features and meet specific conditions:
- Puttable financial instruments (for example, some shares issued by co-operative entities, funds and some partnership interests).
- Instruments or components of instruments 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 (for example, some shares issued by limited life entities).
The classification of the financial instrument as either debt or equity is based on the substance of the contractual arrangement of the instrument rather than its legal form. This means, for example, that a redeemable preference share, which is economically the same as a bond, is accounted for in the same way as a bond. The redeemable preference share is therefore treated as a liability rather than equity, even though legally it is a share of the issuer.
Other instruments may not be as straightforward. An analysis of the terms of each instrument in light of the detailed classification requirements is necessary, particularly as some financial instruments contain both liability and equity features. Such instruments, for example, bonds that are convertible into a fixed number of equity shares, are accounted for as separate liability and equity (being the option to convert if all the criteria for equity are met) components.
The treatment of interest, dividends, losses and gains in the income statement follows the classification of the related instrument. If a preference share is classified as a liability, its coupon is shown as interest. However, the discretionary coupon on an instrument that is treated as equity is shown as a distribution within equity.