IAS 32 - Financial Instruments: Presentation (detailed review)

Objective

This standard prescribes the guidelines for the presentation of financial instrument either as financial asset, financial liability or equity instrument from the issuer’s perspective. It also provides the guidelines for the accounting treatment of the interest, dividend and gains or losses related to financial instruments and the circumstances, when a financial asset can be off set with a financial liability.
However, the recognition and measurement rules for financial instrument are covered under IFRS 9 and related disclosure requirements are covered under IFRS 7

Scope

The requirements of this standard are applicable to all types of financial instruments except for the following:

• Investments in subsidiary, associate or joint venture which are measured at cost in the separate financial statements of acquirer

• The rights and obligations related to employee benefit plans which are covered under IAS 19

• The rights and obligations related to insurance contracts which are covered under IFRS 4

• The rights and obligations related to share based payment which are covered under IFRS 2

• However, this standard is applicable to those contracts, involving non-financial items which can be settled net in cash or another financial instrument, as if the contracts are financial instruments, other than the contracts which were established and held with the intention of the receipt or delivery of the underlying non-financial item as per the expected usage, purchase or sale requirements of the entity. These include:

a) When the contractual terms allow each party to settle the contract net in cash or another financial instrument

b) When the entity has past practices to settle such contracts net in cash or another financial instrument, even though it is not explicit in the terms of the contract (whether with the counter party by selling the contract before its exercise or expiry)

c) When for such contracts, the entity has past practices to take the delivery of underlying non-financial item and selling it within a short time period after delivery to earn profit from short term fluctuations in price that non financial item

d) When the non-financial item involving the contract is readily convertible into cash

 

Definitions

Financial Instrument

It is a contract which gives rise to a financial asset of the one party and a financial liability or equity instrument of the other party.

Financial Asset

It is any asset which is:

a) Cash

b) Equity instrument of the other enterprise

c) A contractual right:

i) To receive cash or other financial asset from the other enterprise

ii) To exchange financial instrument with the other party under the terms which are potentially favorable to the enterprise (Derivatives)

d) The contracts which are settled in own equity instruments of the entity and are:

i) Non-derivative contracts, under which entity is obliged to receive variable number of it’s own equity instruments

ii) Derivative contracts are settled other than by the exchange of fixed amount of cash or other financial asset for fixed number of own equity instruments of the entity.

For this purpose the entity’s own equity instruments do not include puttable instruments which are classified as equity instrument as per the requirements of this standard

For Example:

• Trade Receivables
• Loan Receivables
• Bank Deposits
• Purchase of Equity Instruments
• Purchase of Loan Notes, Debentures or Bonds
• Term Finance Certificates

However, property, plant and equipments, intangible assets and inventory are not financial assets as these does not contain present right to receive cash.

Financial Liability:

It is any liability which is contractual obligation:

a) To pay cash or another financial asset to the other enterprise

b) To exchange financial instrument with the other party under the terms which are potentially un-favorable to the enterprise (Derivatives)

c) The contracts which are settled in own equity instruments of the entity and are:

i) Non-derivative contracts under which entity is obliged to deliver variable number of it’s own equity instruments

ii) Derivative contracts and are settled other than by the exchange of fixed amount of cash or other financial asset for fixed number of the own equity instruments of the entity.

For this purpose the entity’s own equity instruments do not include puttable instruments which are classified as equity instruments as per the requirements of this standard

For Example:

• Trade Payables
• Loan Payables
• Expenses Payables
• Issue of Loan Notes, Debentures or Bonds

Equity Instrument

The instrument which reflects the residual interest in the assets of the entity after the deduction of all the liabilities and gives holder the right to participate in the net assets of the entity in the event of liquidation, is termed as equity instrument

It includes neither an obligation to pay cash nor the contracts under which entity is obliged to deliver variable number of it’s own equity instruments.

E.g.

• Issue of ordinary shares
• Issue of irredeemable preference shares

Presentation of Financial Instrument

The classification and presentation of financial instrument depends upon the following:

• Definition of element i.e. financial asset. financial liability and equity instrument and
• The substance of the contractual terms relating to the instrument

For Example:

• The redeemable preference shares issued by the entity, and which are redeemable on some certain future date for the underlying value of the instrument will be classified as financial liability as it involves an unconditional obligation to pay cash

• The puttable instruments issued by the entity, which give the holder the right to put back the instrument to the issuer at any time in future for the underlying value of  the instrument, will be classified as financial liability as it involves an unconditional obligation to pay cash

• The puttable instruments issued by the entity, which give holder the right to put back the instrument to the issuer only at the time of liquidation, for the pro-rata share in net assets of the entity, will be classified as equity instrument as it includes no obligation to pay cash

Compound Financial Instrument

Sometimes an entity issues a financial instrument, which contains more than one elements or aspects relating to its settlement such financial instruments are termed as compound or hybrid financial instrument

• For example, a Convertible Bond includes more than one elements or aspects relating to its settlement, one is the entity’s obligation to pay cash on redemption which is financial liability and another is the holder’s option to convert the loan note into ordinary shares of the issuer entity which is equity instrument for the issuer. Another example includes the issue of Loan Note with a detachable share warrant.

• This standard requires that the issuer of compound financial instrument should classify the instrument’s equity component as equity and liability component as liability right on its initial recognition. For this purpose, the entity will determine the value of the liability component by measuring the fair value of similar liability without conversion option and then this is deducted from the fair value of compound financial instrument as whole, and the equity component will be allocated the residual amount

• After initial recognition of the equity component and liability component with the respective amounts as per the method mentioned above, the subsequent changes in the value of liability will be recognized in the statement of profit or loss i.e. interest cost

• At maturity of the compound financial instrument, if the instrument holders require the issuer of the compound financial instrument to issue ordinary shares on redemption, then the liability component is de-recognized on maturity and will be transferred to equity for the issuance of ordinary shares

• The entity will recognize both equity component and liability component in respect of compound financial instrument in the statement of financial position and this classification will not be affected by the likelihood of the settlement method

Treasury Shares

If an entity buys back its own equity instruments, these are termed as treasury shares and these are accounted for as follows:

• The treasury shares are recorded at purchase price including transaction cost
• These are presented as deduction from equity in the statement of financial position
• Any gain or loss arising on cancellation or re-issuance of treasury shares will be recognized in equity

Interest and Dividend

The interest or dividend relating to the financial instrument will be accounted for as follows:

• Any interest or dividend income relating to the financial asset will be reported to statement of profit or loss
• Any interest expense relating to the instruments classified as financial liability will be reported to statement of profit or loss
• Dividend distribution to the equity instrument holders will be charged directly against equity i.e. retained earnings
• Any transaction cost for the equity instrument will be deducted from the equity

Offsetting Financial Asset and Financial Liability

The entity may offset a financial asset and a financial liability and can present the net amount in the statement of financial position in the following circumstances only:

• The entity has a present legal enforceable right, to set off the recorded value of financial asset and financial liability, and

• The entity has intention to settle the financial asset and financial liability, either on a net basis, or to realize the financial asset and settle the financial liability at the same time.

Worked Example

AB Ltd issued 2,000 6% convertible bonds at parvalue of $1,000 per bond, on 1 January 2007. The bonds are redeemable after 3 years at par or alternatively the holder can chose to convert the convertible bonds into ordinary shares of AB Ltd on the basis of 250 ordinary shares for each $1,000 of bond.
The entity has identified that the similar bond without the conversion option will require a market interest rate of 9%.

Required

How the convertible bonds will be accounted for in the financial statements of AB Ltd for the year to 31 December 2007?

Solution:

Statement of Profit or Loss	31.12.07
	$
Interest Expense (W4)	(166,284)
Total Charge	(166,284)

Statement of Financial Position	31.12.07
	$
Non-Current Liabilities
6% Convertible Bond (W3)	1,893,884
Reserves
Equity Option (W1)	152,400

 

(W1)

The convertible bond is a compound financial instrument as it contains more than one elements relating to its settlement, one is the entity’s obligation to pay cash on redemption which is financial liability and another is the holder’s option to convert the loan note into ordinary shares of the issuer entity which is equity instrument for the issuer.
IAS 32 requires that the issuer of compound financial instrument should classify such instrument's equity component as equity and liability component as liability right on its initial recognition. For this purpose, the entity will first determine the value of the liability component by measuring the fair value of similar liability without conversion option and then this is deducted from the fair value of compound financial instrument as whole, and the equity component will be allocated the residual amount as follows:

Equity = Fair Value of Consideration – Present Value of Loan
Received taken  at market interest rate

= (2,000 × $1,000) – [(A.F × P.C.F) + (D.F × R.V)]

 

= $2,000,000 – [(2.5313 × $120,000) + (0.772 × $2,000,000)]

= $2,000,000 – $1,847,600

Equity = $152,400

 

Date of Issue (1 January 2007)

Cash a/c  $2,000,000
Equity a/c $152,400
  Loan a/c $1,847,600 

 

(W2)

Annuity Factor (A.F) = 1 - (1 + r)-n / r

= 1 – (1 + 0.09)-3/ 0.09= 2.5313

Periodical Cash Flow (P.C.F) = $2,000,000 × 6% = $120,000

Discount Factor (D.F) = (1 + r)-n
 = (1 + 0.09)-3 = 0.772

Redemption Value (R.V) = $2,000,000

(W3) For Loan Component

Year	Interest Expense	Interest Paid	Balance	Loan
	$	$	$	$
	(1847600 × 9%)	(2,000,000 × 6%)
01.01.07				1,847,600
31.12.07	166,284	120,000	46,284	1,893,884

(W4)

Interest Expense a/c $166,284
  Bank a/c $120,000
  Loan a/c $46,284