IAS 32_ Financial Instruments Presentation

IAS 32 is a standard that focuses on the presentation of financial instruments on a company's financial statement. It classifies financial instruments as liabilities or equity and provides rules for offsetting financial assets and liabilities. The standard has undergone revisions and amendments over the years to keep up with changes in the financial market. It is interconnected with other standards such as IFRS 9, IFRS 7, and IFRS 18. The objective of IAS 32 is to establish principles for presenting financial instruments from the perspective of the issuer. It covers the classification of financial instruments, treatment of related interest, dividends, losses, and gains, and conditions for offsetting. However, it does not cover recognition and measurement, which is covered by IFRS 9, nor does it cover disclosures, which are covered by IFRS 7. The standard applies to all entities and all types of financial instruments, with some specific exceptions, such as interest in subsidiaries, asso All right, welcome to the Deep Dive. Today, we're taking a deep dive into IAS 32, financial instruments, presentation, based on some great sources that you provided. We really want to break down this complex standard and kind of give you a grasp on the essentials of how entities classify financial instruments as liabilities or equity, and then also when they can offset financial assets and financial liabilities. So let's jump right into it. I mean, this is a pretty needy standard. It is, yeah. No, it's one of those ones that sounds very technical. The name itself, financial instruments, presentation, it doesn't maybe sound that exciting, but actually, at its heart, this is about understanding how companies are financed, what their obligations are, and really giving you a clear picture of their financial health. Yeah, it's not just about the balance sheet. This is really about understanding the underpinnings of a company's financial position. Exactly. So maybe we can start just with a quick overview. You know, IAS 32 has quite a history. It does, yeah. What's kind of the Sparknotes version of how we got here? Well, it goes back, you know, a while. Okay. The initial standard was issued in June 1995. It was actually called Financial Instruments, Disclosure and Presentation. Oh, okay. It was issued by the International Accounting Standards Committee. Okay. So that's quite a mouthful. Yeah. But you can see, even back then, right from the start, they were focused on making sure this information was disclosed and presented clearly. So there were a few amendments early on, 1998 and 2000, just refining things, making sure they were keeping pace with how these instruments were evolving. But then in December 2003, there was a revised version of IAS 32 that was issued, and this was issued by the International Accounting Standards Board. The IASB took over the responsibility from the IASC, and this was quite a significant revision because it actually consolidated the guidance from a number of different interpretations. So you had SIC 5, SIC 16, SIC 17. There was even a draft interpretation called SIC D34. Right. That they kind of pulled in and brought under the umbrella of the main standard. So it was a real streamlining, pulling everything together. And then in 2005, the name actually changed to what we know it as now, financial instruments presentation. And that was because all of the disclosure requirements were moved to a new standard, IFRS 7 financial instruments disclosures. So that kind of cleared the way for IAS 32 to focus solely on how these instruments are actually presented on the face of a financial statement. Not in the notes anymore. Exactly, on the main financial statements. But the story doesn't end there. Since then, there have been a number of other amendments, you know, refining and clarifying various aspects of IAS 32. What are some of the highlights? So in February 2008, there was a significant amendment that really addressed the classification of certain potable instruments. Okay. And obligations arising on liquidation. Essentially allowing certain instruments that might have looked like debt to be presented as equity. But, you know, under quite specific and narrow conditions. I think we're definitely gonna have to unpack that potable instrument piece, because I think that's where a lot of the complexity comes in. Yeah, it's where things get quite nuanced. Absolutely, yeah. And then we had another amendment in October 2009. This one was about classifying certain rights denominated in a foreign currency. Okay. As equity. And then in December 2011, there were some clarifications to the offsetting criteria. Right. Just to ensure that the, you know, those rules were applied consistently. And then more recently, in May 2017, there were some amendments specifically dealing with treasury shares. Okay. And that was really, because of the introduction of IFRS 17, the insurance contracts standard. Okay. So, you know, that just highlights the interconnectedness. Yeah. Of the standards. And, you know, how when one standard changes, it often has knock-on effects for other standards. Well, it's almost like this living document that's constantly being updated as things change. Exactly, it's not static. You know, it has to evolve to reflect the changing nature of the financial markets and the instruments that are out there. Well, and it seems like IS32 has been touched by a lot of different standards. What are some of the other standards that have led to some changes? Yeah, I mean, it's quite a long list, actually. So, you know, we've had standards like IFRS 10 and 11, which deal with consolidation. IFRS 13, which, as you know, is all about fair value measurement. IAS 1, which is the presentation standard itself. IFRS 7, of course. And then there's IFRS 9, which is the big one, the recognition and measurement standard. Right. IFRS 15, which is about revenue. IFRS 16, which is leases. And even the brand new standard, IFRS 18, which is the new presentation standard that will replace IAS 1. Okay. So, you know, all of those standards have led to some minor amendments, you know, tweaks here and there to IS32. Right. But, you know, it just shows how interconnected the whole framework is. Right. And, you know, the IS32 is really, it's like a central piece. Right. The financial reporting jigsaw. It is, yeah. It's really fundamental. So, with all this background, maybe we can get to the core of what IS32 is trying to achieve. What's the objective of this standard? So, essentially, the objective of IAS 32 is to establish principles for presenting financial instruments, you know, as liabilities or equity. Okay. And for offsetting financial assets and financial liabilities. Yeah. But, importantly, this is all from the perspective of the issuer. Right. So, the company that's issued the instrument. Okay. So, the standard focuses on a few key things. First of all, classifying financial instruments. So, are they financial assets, financial liabilities, or equity instruments? Then it looks at how to treat the related interest, dividends, losses, and gains. And then, finally, you know, it sets out the conditions for offsetting. But, you know, it's important to remember that IAS 32 isn't the whole story. Right. When it comes to financial instruments. Right. So, it doesn't deal with the recognition and measurement. Right, that's IFRS 9. That's IFRS 9, exactly. And it doesn't cover the disclosures. Right, IFRS 7. Which are dealt with in IFRS 7. Okay, so it's really just about how they're presented. Yeah, it's that presentation piece on the face of the financial statements. So, who needs to worry about IAS 32? Well, the scope of the standard is very broad. Okay. It applies to all entities and all types of financial instruments. Okay. But there are a few specific exceptions. Okay, so let's quickly go through those exceptions just to be clear on the boundaries here. Sure. So, the first one is interest in subsidiaries, associates, and joint ventures. Okay. So, those are generally excluded from the scope. Right. Because they're covered by other standards. So, IFRS 10, IAS 27, IAS 28. Okay. But there's a bit of a nuance here. Okay. So, if those standards require or permit an entity to account for their interest in a subsidiary, associate, or joint venture under IFRS 9, then IAS 32 would apply in those specific circumstances. Okay. And IAS 32 only applies to derivatives. Okay. That are linked to interest in subsidiaries, associates, and joint ventures. So, you have a general rule that there are some exceptions there? Exactly, yeah. Okay, what else is excluded? Employer's rights and obligations under employee benefit plans. Right. So, those are covered by IFS 19. Okay. And then we have insurance contracts. Okay. And investment contracts with discretionary participation features. Okay. Generally within the scope of IFRS 17. Right. But, again, there are a few exceptions even within that. Right. So, IAS 32 would apply to embedded derivatives that are required to be separated from an insurance contract. Right. Under IFRS 9. So, if IFRS 9 says you have to separate that derivative, then IAS 32 kicks in. Okay. It also applies to a separated investment component. Okay. That's from an IFRS 17 contract. Yeah. And that particular component is itself in the scope of IFRS 17. Right. It would also apply to financial guarantee contracts. Okay. That are accounted for under IFRS 9. Okay. Certain rights and obligations under credit card contracts. Okay. That meet the definition of insurance contracts that they're accounted for under IFRS 9. And lastly, if an entity elects to apply IFRS 9 instead of IFRS 17. Okay. To an insurance contract that has a discretionary participation feature. Okay. Where the compensation is limited to the amount of the policyholder's obligation. Okay. It sounds like you need your handy IFRS cheat sheet to kind of keep track of all of these different... It does get a little bit tricky, yeah. Yeah, yeah. And then the final exclusion is financial instruments. Okay. Contracts and obligations under share-based payment transactions. Right. So, those are generally covered by IFRS 2. Okay. But there is, again, a little bit of a nuance here. Okay. So, contracts that fall within the scope of paragraphs 8 to 10 of IAS 32. Okay. Are included in the scope of IAS 32. Okay. And we'll get to what those paragraphs are about a bit later. Okay, yeah. And then also the accounting for treasury shares. Okay. Under IAS 32 always applies. Right. Even though they're related to share-based payment transactions. So, that's the main... That's a lot to keep track of. It is, yeah. Yeah. It's quite a complex area. Okay. And then final exclusion. Oh, there's one more. There's one more, yeah. Okay. Contracts to buy or sell a non-financial item. Okay. So, for example, a contract to buy raw materials. Right. Those are generally outside the scope of IAS 32. Okay. If they are held for the entity's expected purchase, sale, or usage requirements. Right, so that's in the normal course of business. Exactly, yeah. Okay. But there is, again, an exception to the exclusion. Okay. So, if that contract can be settled net in cash or another financial instrument. Okay. Or by exchanging financial instruments, then it would be treated as a financial instrument under IAS 32. Okay. And that could be because the terms of the contract permit net settlement. Okay. Or it could be because there's a past practice of net settling similar contracts. Okay. It could be because there's a practice of taking delivery of the item and then selling it shortly afterwards for a profit. Okay. Or it could be because the item that's the subject of the contract is readily convertible to cash. Okay. So, there are various reasons. So, it's not about the thing itself. Exactly, it's about how that contract behaves. Yeah. Yeah. And lastly, if a company chooses to account for such a contract at fair value through profit or loss. Okay. Under IFRS 9. Right. Then IAS 32 would also apply. Okay. So, there are those specific exceptions. Okay, those are some pretty tricky exceptions. But I think we've laid out the groundwork. So, let's get to the meat of the matter. Okay. We need to define some key terms. So, what is a financial instrument under IAS 32? Well, the definition of a financial instrument is actually quite simple. It's any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Okay, so it's always two sides to that coin. Exactly, yeah. Yeah, okay. So, what's a financial asset? Okay, so a financial asset is defined as any asset that is cash. Right. An equity instrument of another entity. Okay. A contractual right to receive cash or another financial asset. Okay. A contractual right to exchange financial instruments with another entity under conditions that are potentially favorable to the entity. Okay. Or a contract that will or may be settled in the entity's own equity instruments. Okay. And is a non-derivative for which the entity is or may be obligated to receive a variable number of the entity's own equity instruments. Or is 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 instrument. Okay, that's a mouthful. So, a financial asset can actually be settled in the entity's own equity instrument. It can, yeah. What are some of the specific examples there? So, specifically, a contract that is a non-derivative for which the entity is or may be obligated to receive a variable number of the entity's own equity instruments. So, variable being the key word there. Right. 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. Okay. But it excludes contracts for the future receipt of the entity's own equity instruments. Okay. Putable instruments classified as equity instruments. Okay. And obligations arising on liquidation. Right, right, which we're gonna get to. Which we're gonna come back to. Okay. Okay, so that's a financial asset. What's a financial liability then? Okay, so a financial liability is defined as any liability that is. Okay. A contractual obligation to deliver cash or another financial asset to another entity. A contractual obligation to exchange financial instruments with another entity under conditions that are potentially unfavorable to the entity. Okay. Or a contract that will or may be settled in the entity's own equity instruments. Right. And is a non-derivative for which the entity is or may be obligated to deliver a variable number of the entity's own equity instruments. Or is 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. Okay, so that's a lot like the financial asset but on the flip side. It is, yeah. It's very similar just looking at it from the other perspective. So instead of receiving cash, you're delivering cash. Instead of receiving another financial asset, you're delivering another financial asset. Okay. And then the conditions for settlement in the entity's own equity instruments are mirrored as well. Okay, so what are the specifics around those own equity settled contracts for liabilities? So again, we're looking at contracts that are non-derivatives for which the entity is or may be obligated to deliver a variable number of its own equity instruments. Okay. Or derivatives 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 its own equity instruments. Okay. But there are some specific things that are excluded from this definition. Okay. So those are contracts for the future delivery of the entity's own equity instruments. Right. Rights, options, or warrants granted prorata to all of the existing holders of the same class of the entity's own equity instruments. Okay. To acquire a fixed number of the entity's own equity instruments for a fixed amount of cash or another financial asset. Okay. So that's a bit of a mouthful, but essentially it's saying that rights issues. Okay. Where the existing shareholders get the right to buy more shares. Right. Proportionally to their existing holdings. Right. Those are classified as equity. And then puttable instruments classified as equity instruments. And obligations arising on liquidation. Okay, and those are those things we keep saying we're gonna get to. Yeah. Okay. All right, so we have financial assets and financial liabilities. What is just equity then? So equity is any contract that evidences a residual interest in the assets of an entity. Right. After deducting all of its liabilities. Okay. So essentially it's what's left over for the owners. Right. After all the debts have been paid. Okay. So, you know, the most common example of that would be ordinary shares. Right. So the shareholders are entitled to whatever's left over. Okay. After all the creditors have been paid. All right, so one term that we hear a lot in accounting is fair value. Yeah. How's that defined in IAS 32? So IAS 32 doesn't actually provide its own definition of fair value. Okay. It refers to IFRS 13. Okay. Fair value measurement. Okay. And that standard defines fair value as the price that would be received to sell an asset. Okay. Or paid to transfer a liability. Okay. In an orderly transaction between market participants. Okay. At the measurement date. Okay, so it's a market-based measure. Exactly. Okay. And then last, lastly, for definitions, we need to define puttable instrument because we've said that a few times now. Yeah, so a puttable instrument is a financial instrument that gives the holder the right to put the instrument back to the issuer. Okay. For cash or another financial asset. Okay. Or is automatically put back to the issuer. Okay. Upon the occurrence of an uncertain future event. Okay. Or the death or retirement of the holder. Okay. So it's basically giving the holder the option to get their money back. Right. You know, either at a specific time. Okay. Or if certain events occur. Okay. So let's get to the really needy part of IAS 32. Okay. You know, the presentation aspect. How do we distinguish between liabilities and equity? Okay, so the general principle is that an entity classifies a financial instrument. Okay. Or its component parts. Okay. On initial recognition. Okay. As a financial liability, a financial asset, or an equity instrument in accordance with the substance of the contractual arrangement. Okay. And the definitions of a financial liability, a financial asset, and an equity instrument. Okay, so it's really about, you know, looking at the contract, the agreement, and what the economic reality of that is. Exactly, yeah. Okay. It's all about substance over form. Okay, so what are the conditions for classifying an instrument as equity? Okay, so a financial instrument is classified as an equity instrument if and only if. Okay. Both of the following conditions are met. Okay. A, the instrument includes no contractual obligation. Okay. To deliver cash or another financial asset to another entity. Or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity. Okay. And B, if the instrument will or may be settled in the entity's own equity instruments. Right. It is either a non-derivative for which the entity is, or may be obligated to deliver a variable number of the entity's own equity instruments. Okay. Or a derivative that will be settled only by the exchange of a fixed amount of cash or another financial asset for a fixed number of the entity's own equity instrument. Okay, so you're saying that a contractual obligation to deliver cash or another financial asset, that that's really what makes something a liability. Exactly, yeah. Okay. So if you have that obligation. Right. Then it's a liability. Okay. Even if it's, you know, the instrument is labeled as equity. Right. So it's really about the substance. Right, the economic substance. Exactly. Okay. And then the second condition is about how it's settled. So if it's settled in the entity's own equity instruments. Okay. Then it has to meet certain conditions to be classified as equity. Okay. And those conditions are really about making sure that it's a genuine equity instrument. Right. And not, you know, disguised as something else. Right. So those are the two main conditions. Okay, and we talked about those specific instruments that are excluded from this definition. Yes. Like the rights issues to existing shareholders. Exactly, yeah. And the puttable instruments and the obligations on liquidation. Yes. So if a contract involves the company's own shares, but doesn't meet both of those conditions, then it's not equity. Exactly, if it doesn't meet both of those conditions, then it can't be classified as equity. Okay. And if it has a contractual obligation to deliver cash or another financial asset, then it's a liability. Okay. Regardless of how it's, you know, dressed up or labeled. And this is where the concept of substance over form really comes into play. Okay. Because, you know, you might have an instrument that's legally in the form of equity. Right. But in substance, it's actually a liability. Okay, so you have to look beyond the legal terms. Exactly, yeah. Okay. You mentioned the puttable instruments and the obligations arising on liquidation. Yeah. Can you elaborate on those exceptions a bit? Yeah, so these are quite specific circumstances. Okay. Where an instrument that might otherwise be classified as a liability can be classified as equity. Okay. So for puttable instruments to be classified as equity, they have to meet a number of conditions. Okay. And these are set out in paragraph 16a and 16b of IS 32. Okay. So firstly, the puttable instrument must entitle the holder to a pro rata share of the net assets of the entity on liquidation. Okay. So essentially, if the company is wound up, the holder of this instrument gets a share of whatever's left over. Okay. In proportion to their holding. Okay. Secondly, the instrument must be in a class of instruments that is subordinate to all other classes of instruments. Okay. So they have no priority on liquidation. Okay. And the instrument doesn't actually need to be converted into a subordinate instrument to be classified as equity. Okay. Thirdly, all financial instruments in that subordinate class must have identical features. Okay. So for example, they must all be puttable. Okay. And they must all have the same formula for determining the repurchase or redemption amount. Okay. Fourthly, apart from the put feature, the instrument must include no contractual obligation to deliver cash or another financial asset to another entity. Right. Or to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity. Okay. And it must not be a contract that will or may be settled in the entity's own equity instruments. That meets the definition of a financial liability. Right. So it has to, you know, it can't be a liability in disguise. Right. Fifthly, the total expected cash flows attributable to the instrument over the life of the instrument must be based substantially. Okay. On the profit or loss. Okay. Or the change in the recognized net assets. Okay. Or the change in the fair value of the recognized and unrecognized net assets of the entity. Okay. Other than those attributable to the instrument itself. Okay. So essentially the cash flows have to be linked to the performance of the entity. Okay. Not, you know, to some external factor. Okay. And then sixthly, the issuer must have no other financial instrument or contract outstanding that has total expected cash flows based substantially. Okay. On the same factors as those used to determine the total expected cash flows attributable to the puttable instruments. Okay. And that substantially restricts or fixes the residual return to the holders of the puttable instruments. So essentially the entity can't have some other instrument out there. Right. That's kind of taking away from the residual return that the holders of the puttable instruments are entitled to. Right. So it's quite a complex set of conditions. It is, yeah. But essentially what they're trying to do is make sure that these puttable instruments are genuinely equity.