Key definitions [IAS 32.

11]

Financial instrument: a contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity.

Financial asset: any asset that is:

cash

an equity instrument of another entity

a contractual right

o to receive cash or another financial asset from another entity; or

o to exchange financial assets or financial liabilities with another entity under

conditions that are potentially favourable to the entity; or

a contract that will or may be settled in the entity's own equity instruments and is:

o a non-derivative for which the entity is or may be obliged to receive a variable

number of the entity's own equity instruments

o 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. For this purpose the entity's own equity instruments do not
include instruments that are themselves contracts for the future receipt or delivery
of the entity's own equity instruments

o puttable instruments classified as equity or certain liabilities arising on liquidation

classified by IAS 32 as equity instruments

Financial liability: any liability that is:

a contractual obligation:

o to deliver cash or another financial asset to another entity; or

o to exchange financial assets or financial liabilities with another entity under

conditions that are potentially unfavourable to the entity; or

a contract that will or may be settled in the entity's own equity instruments and is
 o a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity's own equity instruments or

o 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. For this purpose the entity's own equity instruments do not
include: instruments that are themselves contracts for the future receipt or
delivery of the entity's own equity instruments; puttable instruments classified as
equity or certain liabilities arising on liquidation classified by IAS 32 as equity
instruments

Equity instrument: Any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.

Fair value: the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction.

The definition of financial instrument used in IAS 32 is the same as that in IAS 39.

Puttable instrument: a financial instrument that gives the holder the right to put the instrument
back to the issuer for cash or another financial asset or is automatically put back to the issuer on
occurrence of an uncertain future event or the death or retirement of the instrument holder.

Classification as liability or equity

The fundamental principle of IAS 32 is that a financial instrument should be classified as either a
financial liability or an equity instrument according to the substance of the contract, not its legal
form, and the definitions of financial liability and equity instrument. Two exceptions from this
principle are certain puttable instruments meeting specific criteria and certain obligations arising
on liquidation (see below). The entity must make the decision at the time the instrument is
initially recognised. The classification is not subsequently changed based on changed
circumstances. [IAS 32.15]

A financial instrument is an equity instrument only if (a) the instrument includes no contractual
obligation to deliver cash or another financial asset to another entity and (b) if the instrument will
or may be settled in the issuer's own equity instruments, it is either:

a non-derivative that includes no contractual obligation for the issuer to deliver a variable
number of its 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 number of its own equity instruments. [IAS 32.16]

Illustration preference shares

If an entity issues preference (preferred) shares that pay a fixed rate of dividend and that have a
mandatory redemption feature at a future date, the substance is that they are a contractual
obligation to deliver cash and, therefore, should be recognised as a liability. [IAS 32.18(a)] In
contrast, preference shares that do not have a fixed maturity, and where the issuer does not have
a contractual obligation to make any payment are equity. In this example even though both
instruments are legally termed preference shares they have different contractual terms and one is
a financial liability while the other is equity.

Illustration issuance of fixed monetary amount of equity instruments

A contractual right or obligation to receive or deliver a number of its own shares or other equity
instruments that varies so that the fair value of the entity's own equity instruments to be received
or delivered equals the fixed monetary amount of the contractual right or obligation is a financial
liability. [IAS 32.20]

Illustration one party has a choice over how an instrument is settled

When a derivative financial instrument gives one party a choice over how it is settled (for
instance, the issuer or the holder can choose settlement net in cash or by exchanging shares for
cash), it is a financial asset or a financial liability unless all of the settlement alternatives would
result in it being an equity instrument. [IAS 32.26]

Contingent settlement provisions

If, as a result of contingent settlement provisions, the issuer does not have an unconditional right
to avoid settlement by delivery of cash or other financial instrument (or otherwise to settle in a
way that it would be a financial liability) the instrument is a financial liability of the issuer,
unless:

the contingent settlement provision is not genuine or

the issuer can only be required to settle the obligation in the event of the issuer's
liquidation or

the instrument has all the features and meets the conditions of IAS 32.16A and 16B for
puttable instruments [IAS 32.25]

Puttable instruments and obligations arising on liquidation

In February 2008, the IASB amended IAS 32 and IAS 1 Presentation of Financial Statements
with respect to the balance sheet classification of puttable financial instruments and obligations
arising only on liquidation. As a result of the amendments, some financial instruments that
currently meet the definition of a financial liability will be classified as equity because they
represent the residual interest in the net assets of the entity. [IAS 32.16A-D]

Classifications of rights issues

In October 2009, the IASB issued an amendment to IAS 32 on the classification of rights issues.
For rights issues offered for a fixed amount of foreign currency current practice appears to
require such issues to be accounted for as derivative liabilities. The amendment states that if such
rights are issued pro rata to an entity's all existing shareholders in the same class for a fixed
amount of currency, they should be classified as equity regardless of the currency in which the
exercise price is denominated.

Compound financial instruments

Some financial instruments sometimes called compound instruments have both a liability and
an equity component from the issuer's perspective. In that case, IAS 32 requires that the
component parts be accounted for and presented separately according to their substance based on
the definitions of liability and equity. The split is made at issuance and not revised for subsequent
changes in market interest rates, share prices, or other event that changes the likelihood that the
conversion option will be exercised. [IAS 32.29-30]

To illustrate, a convertible bond contains two components. One is a financial liability, namely the
issuer's contractual obligation to pay cash, and the other is an equity instrument, namely the
holder's option to convert into common shares. Another example is debt issued with detachable
share purchase warrants.

When the initial carrying amount of a compound financial instrument is required to be allocated
to its equity and liability components, the equity component is assigned the residual amount after
deducting from the fair value of the instrument as a whole the amount separately determined for
the liability component. [IAS 32.32]

Interest, dividends, gains, and losses relating to an instrument classified as a liability should be
reported in profit or loss. This means that dividend payments on preferred shares classified as
liabilities are treated as expenses. On the other hand, distributions (such as dividends) to holders
of a financial instrument classified as equity should be charged directly against equity, not
against earnings. [IAS 32.35]

Transaction costs of an equity transaction are deducted from equity. Transaction costs related to
an issue of a compound financial instrument are allocated to the liability and equity components
in proportion to the allocation of proceeds.

Treasury shares

The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is
deducted from equity. Gain or loss is not recognised on the purchase, sale, issue, or cancellation
of treasury shares. Treasury shares may be acquired and held by the entity or by other members
of the consolidated group. Consideration paid or received is recognised directly in equity. [IAS
32.33]

Offsetting
IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It
specifies that a financial asset and a financial liability should be offset and the net amount
reported when, and only when, an entity: [IAS 32.42]

has a legally enforceable right to set off the amounts; and

intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously. [IAS 32.48]

Costs of issuing or reacquiring equity instruments

Costs of issuing or reacquiring equity instruments (other than in a business combination) are
accounted for as a deduction from equity, net of any related income tax benefit. [IAS 32.35]

Disclosures

Financial instruments disclosures are in IFRS 7 Financial Instruments: Disclosures, and no

longer in IAS 32.

The disclosures relating to treasury shares are in IAS 1 Presentation of Financial Statements and
IAS 24 Related Parties for share repurchases from related parties. [IAS 32.34 and 39]