How to Present Financial Instruments under IAS 32

There are three IFRS covering the area of the most complex IFRS topic – financial instruments:

1. IAS 32 Presentation of Financial Statements – this standard contains basic definitions and rules for presenting of financial instruments;
2. IFRS 7 Financial Instruments: Disclosures – here, you can find a list of all necessary information that you need to include in the notes to the financial statements about your financial instruments, and
3. IFRS 9 Financial Instruments – the newest one and the most famous one because it contains all the rules about the recognition, derecognition, measurement of financial instruments and other topics.

You can find the summary of IFRS 9 here and summary of IFRS 7 here.

Also, I dedicated a fair number of articles and podcasts to the financial instruments, so you can browse them here.

In today’s article, I would like to come back to basics, because financial instruments can be quite confusing and we need to explain clearly what they are and how to present them.
 

What is the objective of IAS 32?

International Accounting Standard 32, or IAS 32, establishes principles for presenting the financial instruments and especially:

• It provides definitions of financial instruments,
• It shows us how to distinguish equity from liabilities,
• It contains the guidance for compound financial instruments,
• It prescribes the rules for presenting the treasury shares
• It states conditions when you can offset a financial asset and a financial liability in your statement of financial position,

just to name a few main topics.
 

What is a financial instrument?

A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. (IAS 32.11)

Here, the contract is important.

This is the main difference between the financial instruments and other assets and liabilities: a contract.

While you don’t have to have any contract to recognize a car or a software program as your non-current asset, you DO have to enter into some sort of a contract to recognize a financial instrument.

You can see three main types of financial instruments arising from the definition:

1. Financial asset;
2. Financial liability; and
3. Equity instrument

Let’s break it down.
 

Definition of a financial asset

In line with IAS 32.11, a financial asset is any asset that is:

• Cash.
  This is crystal clear – all petty cash, bank accounts and other cash equivalents are financial assets.
• An equity instrument of another entity.
  Example: if you buy shares of Apple on the stock exchange, then Apple shares are your financial asset (and equity instrument of Apple).
• A contractual right to:
  • Receive cash or another financial asset from another entity.
    Example: trade receivables, issued loans, purchased bonds. Or,
  • To exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity.
    Example: purchased call options, purchased put options.
• A contract that will or may be settled in the entity’s own equity instruments and is:
  • a non-derivative for which the entity is or may be obliged to receive a variable a number of the entity’s own equity instruments, or
  • a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

  Examples: please see “Transactions in own equity” below. It is much easier to explain this part on the example.

Definition of a financial liability

Under IAS 32.11, a financial liability is any liability that is:

• A contractual obligation to:
  • Deliver cash or another financial asset from another entity.
    Example: trade payables, taken loans, issued bonds. Or,
  • To exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity.
    Example: written call options, written put options.
• A contract that will or may be settled in the entity’s own equity instruments and is:
  • a non-derivative for which the entity is or may be obliged to deliver a variable a number of the entity’s own equity instruments, or
  • a derivative that will or may be settled other than by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity’s own equity instruments.

  Examples: please see “Transactions in own equity” below. Example will make it clear for you.

There are few exceptions when the instrument meets the definition of a financial liability, but it is still classified as an equity instrument, for example puttable instruments or obligations on liquidation.
 

Definition of an equity instrument

In line with IAS 32.11, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

So, equity instrument is basically YOUR own equity and it may not include only shares, but also certain warrants, options and other instruments.

You can get more insights into the definitions of financial instruments here.
 

How to present financial instruments?

The fundamental rule in IAS 32.15 is to classify the financial instruments on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with:

• The substance of the contract, and
• The definitions of a financial asset, financial liability and an equity instrument.

It not such a big deal to classify financial assets, but sometimes there are challenges to distinguish between financial liabilities and equity instruments.
 

Equity or liability?

The main question to respond when classifying an instrument as either a financial liability or an equity instrument is:

Is there a contractual obligation to deliver cash or another financial asset to another entity?

Or alternatively, to exchange financial assets or financial liabilities under potentially unfavorable conditions?

If yes, then the instrument is a financial liability.

If not, then the instrument is an equity instrument.

However, what if there is an obligation to deliver own equity instruments and not cash or another financial asset?

We are getting to back to the difficult part of the definitions – transactions in own equity.
 

Transactions in own equity

According to IAS 32.16, an equity instrument is:

• A non-derivative that includes no contractual obligation to deliver a variable number of own equity instruments, or
• A derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial asset for a fixed amount of its own equity instruments.

To make it simple, two most important things to watch out are:

1. Are equity instruments own or issued by somebody else?
2. Is the amount to deliver or exchange fixed or variable?

Let me show you a few illustrations:

1. You sell an option to deliver 100 shares of Apple to your friend.
   This is a financial liability, because the shares are NOT YOUR OWN shares. They are shares of somebody else (Apple in this case).
2. You sell an option to deliver your own shares in total value of CU 100 to your friend.
   This is a financial liability, too, because although the shares are yours, their number is variable. Why?
   Because, the exact number of shares will depend on the current price of the share at the delivery.
   You will calculate it as 100 divided by the market price of one share.
3. You sell an option to deliver 100 pieces of your own shares to your friend.
   This is an equity instrument, because the shares are yours and their amount is fixed – 100.

Compound financial instruments

Some financial instruments have both liability and equity component.

For example, a convertible bond where an issuer issues a bond to a holder and the holder has an option to get the bond repaid by some number of the ordinary shares of issuer instead of taking cash.

There are two components:

1. A financial liability: a loan, because the issuer has a liability to settle the loan with transfer of cash; and
2. An equity instrument: a call option written to the holder to deliver some number of ordinary shares.

In this case, an issuer needs to classify and present these two elements separately:

• The loan element is presented as a financial liability, and
• The call option element is presented as an equity instrument.

There are more methods to do so and you can learn more about accounting for compound financial instruments in this article.

Also, the IFRS Kit contains loads of examples and illustrations about financial instruments including warrants, compound instruments and more, so if interested, check it out here.
 

Treasury shares

Treasury shares are the term used by IAS 32 for own shares.

If you acquire own shares, you need to deduct them from equity and NOT recognize them as financial assets.
 

Offsetting a financial asset and a financial liability

Offsetting means presenting a financial asset and a financial liability as one single net amount in the statement of financial position.

IAS 32.42 sets the following rules when you must offset a financial asset with a financial liability:

1. When you have a legally enforceable right to set off the recognized amounts, and
2. When you intend to settle on a net basis, or realize the asset and the liability simultaneously.

Small illustration:

Imagine you run a supermarket and you buy goods from a local producer.

You purchased some goods and you have a liability of CU 1 000.

But, you charged promotion fees amounting to CU 50 to your supplier, because you issue a leaflet and include his products there.

So, at the same time, you have a receivable of CU 50.

You can present these two items as a net financial liability of CU 950, if there are no legal restrictions to do so and if you agreed with the supplier somewhere in the contract that you would make net payments.
 

IAS 32 Video

IAS 32 arranges also other issues, such as puttable financial instruments, classification of rights issues, contingent settlement provisions and others.

You can watch the video with the summary of IAS 32 here:

Any comments or questions? Please leave me a message below. Thank you!