A) it does not any contractual obligations (deliver cash or exchange asset / liability)
B) it is either a non derivative (with no contractual obligations) alternatively
C) if it is a derivative then it is to be settled in either cash or by an asset for a fixed number of the entity’s own equity instruments
What is a financial instrument-2?
When an entity is obligated to buy back its own shares (treasury shares) a liability exists
In a situation where an entity can exchange its own equity instruments to receive or deliver shares ( with a fixed amount) then this arrangement / contract is not an equity instrument but a financial asset or a financial liability
What is a financial instrument-3?
An instrument that gives right to the holder to sell it to the issuer for either cash or another financial asset is a liability to the issuer
An instrument is a liability when settlement depends on some uncertain events
A derivative financial instrument is either an asset or a liability when there is a choice for settlement.
What is a financial instrument-4?
While measuring a financial instrument, the asset and liability components are first separated & then the residual is considered as equity component.
Treasury shares- when an entity acquires or resells its own shares, this transaction represents a change of ownership and consequently no gain or loss arises.
The treasury share transaction costs are equity related and are deducted from equity.
Scope within IAS 32- 1
This standard is applicable to all financial instruments except:
Insurance contracts. However, where such contracts are embedded derivatives (IAS 39) then apply IFRS 4 (recognition and measurement of financial instruments)
Instruments where share based payments are involved, apply IFRS 2
Scope within IAS 32- 2
The standard applies to contracts to buy or sell non financial instruments which can be settled in cash by some other financial instruments
When settlement can be in cash / other financial instruments then watch for these: a) the contracts demand this type of settlements, b) when contract is not explicit then the traditional settlements like cash or other instruments will be in order, c) when it is the usual practice of the entity to quickly buy/sell to make short term gains or losses
When a contract is readily convertible in cash
A written option that can be settled in cash, cannot be settled in any other way.
A financial instrument is a contract that gives rise to a financial asset and a liability in two different entities
A financial asset is cash, equities in another entity, a contractual right to receive cash or exchange with another asset or liability that is potentially favorable to the entity.
A financial asset is also a contract that may be settled by the entity’s own equity if it is a non derivative. If it is a derivative, then it may be settled for either cash or another asset. An entity’s own equity instruments will not be included in these transactions.
A financial liability can be a contractual obligation to deliver cash or another asset or exchange financial assets / liabilities under unfavorable conditions to the entity.
A liability can also be a contract which can be settled with the entity’s own equity instrument which is when a non derivative can be settled by a certain number of the entity’s own equity instrument and if a derivative then settlement can be by means other than cash
An equity instrument is a contract that has a residual interest after deducting all liabilities
Fair value could be defined as a value that could be exchanged or liabilities settled between settled between willing and knowledgeable parties in an arm’s length transaction.
A puttable instrument is sellable for cash or any other financial asset or it is automatically transferred to the issuers on the occurrence of an uncertain event.
Contracts usually have clear economic consequences and the related parties have little discretionary power to avoid.
Entities include individuals, partnerships, incorporated bodies etc.
The issuer of a financial instrument will classify the instrument either as an asset or an equity instrument,
Under certain conditions, an issuer will define an equity instrument if it has no contractual obligations to deliver cash or financial asset of another entity or to exchange any assets / liabilities under unfavorable conditions. If the instrument is to be settled with the issuer’s own equity instrument then if it is a non-derivative that includes no contractual obligations to deliver the entity’s own equity or if it is a derivative that would require settlement with a fixed amount of cash or a fixed number of shares of the entity.
These include contractual obligations for the issuer to repurchase or redeem instruments for cash or another financial asset when sold.
What is an equity instrument?- if an instrument entitles the holder to a pro-rata share after payment of all liabilities on liquidation. A pro-rata share is determined on dividing an entity’s assets into equal units of amounts and multiply the units held by the holder with the unit amount. The instrument is subordinate to all other instruments. A subordinate instrument has no priority over other claims to the assets. All subordinate instruments are puttable and the formula to calculate the redemption price is the same in that class.
Puttable instruments do not have any obligations apart from the contractual obligations by the issuer.
Obligations on liquidation
Some financial instruments hold conditions to transfer pro rata share of net assets to the holder on liquidation. Obligation arises when it is beyond control of the entity or it is uncertain to occur.
An equity instrument has features such as the holder is entitled to pro rata share on liquidation. The share is determined by unit rates multiplied by the number of units held. These are subordinate instruments. All subordinate instruments have identical obligations.
Reclassification of puttable instruments An entity will reclassify a financial instrument as an equity instrument when it has all the necessary features. Reclassification will be done when an equity instrument ceases to have the specific features. The difference between the carrying amount of an equity instrument and the fair value of a financial instrument will be recognized in equity at the date of reclassification. To reclassify a financial liability as equity when it has all the requisite features. It is to be re-measured at carrying value at reclassification.
Absence of contractual obligations With some exceptions, a financial liability differs from equity as it has contractual liabilities to deliver either cash or another financial asset. Substance rather the legal form governs the financial liability’s classification. Such as a preference share has a mandatory financial liability for redemption. When a holder of a financial instrument has the right to sell it back to the issuer for cash or another financial asset then it is a financial liability. If an entity does not have the right to avoid a liability by payment of cash or another asset then the obligation is a financial liability.
Even if it is contractual to settle an instrument with an entity’s own shares, this situation does not necessarily make it an equity instrument.
In a settlement, if an entity receives its own shares, then it is financial asset or a financial liability contract.
It is a financial liability when the entity has to buy back its own shares for cash.
A contract that requires delivery of an entity’s own shares in exchange for cash or another asset is a financial asset or a financial liability.
Contingent settlement provisions
A contingent settlement requires a financial instrument to deliver cash or another financial asset on the happening of a certain event in future which will render the instrument as a financial liability. Such events are beyond control of an entity.
When an instrument holder has a choice of settlement such as by net cash or by exchanging shares then the instrument is either a financial asset or a financial liability unless all the settlement alternatives point to the instrument being an equity instrument.
Financial instruments are either settled in cash or by exchanging shares. These are not equity instruments.
Compound financial instruments The issuer of a non derivative financial instrument will examine the terms to determine whether the instrument contains both liability and equity elements in which case such different components will be separately displayed. The instrument holders may have the option to convert financial instruments into equity ones at a later date. Example: convertible bonds converted into a fixed number of ordinary shares.
If an entity acquires its own shares or equity instruments then these are termed as treasury shares and these are then deducted from entity’s shareholders equity.
No gain or loss arise on an entity’s own equity transactions.
All the treasury share related payments and receipts are accounted for under equity.
The details of all the treasury shares held are to be disclosed in the financial statements.
Interest, dividends, gains and losses
Interests, dividends, gains and losses relating to a financial instrument or a component that is a financial liability, shall be recognized in the profit and loss accounts.
Any dividend distributions to holders of financial instruments along with any transaction costs shall be directly debited to equity net of any income tax benefits.
The classification of any instrument such as whether it is a financial liability or an equity instrument will determine whether the related costs such as interests etc. will be recognized in the profit and loss.
The issue costs of equities should be deducted from equity. These costs are typically legal, accounting etc.
If dividends are classified as an expense then they should be presented in the statement of comprehensive income.
The requirements of IAS 1 and IFRS 7 are to be complied with.
Offsetting a financial asset and a financial liability
a financial asset and a financial liability shall be offset and the net amount shall be presented in the financial statements under the following circumstances:
A) there is a legal enforceable right of setoff
B) the entity wants to settle on a net basis or wants to realize asset and settle liability simultaneously
When transfer of an asset does not qualify for de-recognition, asset and liability set offs do not take place.
This standard requires a set off when doing so presents the future cash flows after settling two or three instruments. Net presentation has to reflect more meaningful expected cash flows.
Offsetting a financial asset and a financial liability (continued)
Offsetting assets with liabilities is generally inappropriate when:
A) several instruments are used to emulate one instrument
B) financial assets and liabilities have the same primary risk exposure (example: assets and liabilities of a portfolio involve different counterparties)
E) obligations arising under an insurance contract
An entity may enter into a multiple instrumental transaction with a single counterparty with a master netting arrangement.
Sundry points The effective date of application of the standard is 1st January 2005 Puttable financial instruments with regards to an entity should apply amendments as per IAS 32 and IAS 1. Puttable financial instruments and obligations arising on liquidation have a limited scope exception not applicable to all entities The standard should be applied retrospectively