IAS 32 – Financial Instruments: Presentation
What is the main focus of IAS 32?
IAS 32 is the earliest of the standards dealing with financial instruments. This Standard mainly addresses issues relating to the definition and distinction between financial assets, financial liabilities, and equity instruments, and the related implications of this distinction for the presentation of various components in the financial statements.
How does IAS 32 define financial assets and financial liabilities?
In general, with respect to the definition and presentation of financial instruments, the Standard adopts a legal approach, giving primary weight to the contractual rights and obligations of the parties under the instrument’s terms, rather than to the legal name of the instrument. Broadly speaking, the most basic type of financial asset is cash or an investment in equity instruments (such as shares) of other entities. Other types of financial assets are those that ultimately result in the basic financial assets mentioned above – such as a contractual right to receive cash (e.g., a deposit or bond) or a contractual right to receive an equity investment in another entity (e.g., a forward contract). Similarly, basic financial liabilities represent a contractual obligation to deliver cash or another financial asset to another party. The definitions of financial assets and financial liabilities therefore focus on contractual rights and obligations, without regard to matters such as the parties’ intentions.
How does IAS 32 interact with IFRS 9?
IFRS 9 Financial Instruments, which builds on the definitions in IAS 32 of financial assets and financial liabilities, deals with their recognition and measurement. Generally, the question of whether a particular item qualifies as a financial asset or financial liability has significant implications, since financial instruments are usually recognised and measured in accordance with IFRS 9 from the date the contract is entered into. For example, the accounting treatment of executory contracts that do not create financial instruments (e.g., a binding contract to purchase property, plant and equipment in the future) is typically off-balance sheet. In contrast, a forward contract that qualifies as a financial instrument (e.g., a forward contract to purchase foreign currency) is classified as a financial instrument and measured at fair value on a recurring basis even before settlement.
Which items are excluded from the scope of IAS 32 and IFRS 9?
Although many items could potentially fall within the definition of financial instruments, both IAS 32 and IFRS 9 scope out certain items that are dealt with under other IFRS Accounting Standards, e.g., employee benefits and Share-based Payments. In addition, practical questions sometimes arise as to whether IAS 32 and IFRS 9 apply to particular items or arrangements.
What is an equity instrument from the issuer’s perspective?
A special type of financial instrument defined and addressed in the Standard is equity instruments (from the perspective of the issuer). While an equity instrument is classified as a financial asset for the investor, it generally does not meet the definition of a financial liability for the issuer, since it does not include an obligation to deliver cash or another financial asset to the holder. The most classic example of an equity instrument is ordinary shares. As a guiding principle, unlike financial assets or financial liabilities, equity instruments issued by the reporting entity (together with directly attributable transaction costs) are classified as equity, and are not subsequently remeasured. That is, their issuance, repurchase or resale do not give rise to gains or losses.
What is the fixed-for-fixed principle under IAS 32?
Furthermore, one of the most significant principles in IAS 32 relates to instruments that are settled through the delivery or receipt of the entity’s own equity instruments. In general, under this principle, only when the number of equity instruments to be delivered by the entity is fixed and the consideration to be received is also fixed, does the instrument meet the definition of an equity instrument. This requirement is often referred to as the “fixed-for-fixed” condition. Otherwise, the instrument is classified as a financial asset or financial liability and accounted for under IFRS 9.
How is the fixed-for-fixed principle applied in practice?
For example, if the reporting entity issues a loan that is to be settled by delivering a variable number of its own shares to the lender, with a fair value equal to the nominal value of the loan plus fixed interest, the instrument is classified and accounted for as a financial liability, since the number of shares to be delivered is not fixed. The classification as a financial liability is not affected by the legal label of the instrument (for instance, even if the loan is described as an advance on shares). A similar result occurs regarding options, forward contracts, or similar instruments where the exercise price or the number of shares to be issued is not fixed.
What is the rationale and limitation of the fixed-for-fixed principle?
The rationale behind the fixed-for-fixed principle is that when the condition is not met, the counterparty does not, in substance, have exposure to the returns and risks of a shareholder. However, the application of this principle can sometimes lead to distorted practical consequences. Among other things, it can result in leverage appearing in the entity’s statement of financial position even if, in practice, no outflows of economic benefits are expected in settling the financial liabilities (since they may be settled in shares, albeit in a variable number).