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Objective of IAS 32 The stated objective of IAS 32 is to enhance financial statement users' understanding of the significance of financial instruments to an entity's financial position, performance, and cash flows. IAS 32 addresses this in a number of ways: Clarifying the classification of a financial instrument issued by an enterprise as a liability or as equity. Prescribing the accounting for treasury shares (a company's own repurchased shares). Prescribing strict conditions under which assets and liabilities may be offset in the balance sheet. Requiring a broad range of disclosures about financial instruments, including information as to their fair values. IAS 32 is a companion to IAS 39 Financial Instruments: Recognition and Measurement. IAS 39 deals with, among other things, initial recognition of financial assets and liabilities, measurement subsequent to initial recognition, impairment, derecognition, and hedge accounting. Scope IAS 32 applies in presenting and disclosing information about all types of financial instruments with the following exceptions: [IAS 32.4] Interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27 Consolidated and Separate Financial Statements, IAS 28Investments in Associates, or IAS 31 Interests in Joint Ventures. However, IAS 32 applies to all derivatives on interests in subsidiaries, associates, or joint ventures. Employers' rights and obligations under employee benefit plans [see IAS 19]. Rights and obligations arising under insurance contracts (this is the subject of a current IASB project). However, IAS 32 applies to a financial instrument that takes the form of an insurance (or reinsurance) contract but that principally involves the transfer of financial risks. Also, IAS 32 applies to derivatives that are embedded in insurance contracts. Contracts for contingent consideration in a business combination [see IFRS 3]. Contracts that require a payment based on climatic, geological or other physical variables (weather derivatives) [see IAS 39]. IAS 32 applies to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, except for contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a non-financial item in accordance with the entity's expected purchase, sale, or usage requirements. [IAS 32.8] 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; 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. 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 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. 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. The enterprise 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 enterprise 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. In contrast, normal preference shares do not have a fixed maturity, and the issuer does not have a contractual obligation to make any payment. Therefore, they are equity. [IAS 32.18] 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] Puttable instruments and obligations arising on liquidation On 14 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. The amendments have detailed criteria for identifying such instruments, but they generally would include: Puttable instruments that are subordinate to all other classes of instruments and that entitle the holder to a pro rata share of the entity's net assets in the event of the entity's liquidation. A puttable instrument is 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 the occurrence of an uncertain future event or the death or retirement of the instrument holder. Instruments, or components of instruments, that are subordinate to all other classes of instruments and that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation. The amendments result from proposals that were in an Exposure Draft published by the Board in June 2006. The amendments are effective for annual periods beginning on or after 1 January 2009. Earlier application is permitted. Click for IASB Press Release (PDF 51k). Click to download a special edition IAS Plus Newsletter on Amendments to IAS 32 and IAS 1 on puttable financial instruments and obligations arising on liquidation (PDF 101k). That newsletter includes the following examples illustrating the types of instruments affected by the new requirements: Classification under Issued financial instrument Classification under amended IAS 32 existing IAS 32 Share puttable Liability Equity throughout its life at fair value, that is also the most subordinate, does not contain any other obligation, with discretionary dividends based on profits of the issuer Share puttable at fair Liability Liability value, that is not the most subordinate Share puttable at fair Liability Compound (part equity, part liability) value only on liquidation, that is also the most subordinate, but contains a fixed non- discretionary dividend Share puttable at fair Liability Equity value only on liquidation, that is also the most subordinate, but contains a fixed discretionary dividend and does not contain any other obligation Any of the instruments Liability Liability described above issued by a subsidiary held by non-controlling parties, in the consolidated financial statements 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 32.28] 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 32.31] Interest, dividends, gains, and losses relating to an instrument classified as a liability should be reported in the income statement. 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] 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 enterprise: [IAS 32.42] has a legally enforceable right to set off the amounts; and Intends either to settle on a net basis, or to realize the asset and settle the liability simultaneously. 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. August 2009: IASB ED on classifications of rights issues On 6 August 2009, the IASB published an exposure draft (ED) of a proposed amendment to IAS 32 Financial Instruments: Presentation on the classification of rights issues. The proposal seeks to clarify the accounting treatment when rights issues are denominated in a currency other than the functional currency of the issuer. A rights issue is a transaction in which an entity issues a right for all existing shareholders of a class, on a pro rata basis, to acquire a fixed number of additional shares at a fixed price. Sometimes, the price is denominated in a currency other than the entity's functional currency because the entity's shares trade in more than one jurisdiction, or for other reasons. Current practice appears to require such issues to be accounted for as derivative liabilities. That is because these rights do not result in the exchange of a fixed amount of cash denominated in the entity�s functional currency for a fixed number of shares because the exercise price changes with movements in foreign exchanges rates. A fixed price in a non-functional currency fails the IAS 32 �fixed for fixed� requirement to be treated as an equity instrument. Therefore, at present, the right is treated as a derivative, with changes in the fair value of the derivative recognised in profit or loss. The proposals in the ED state that if such rights are issued pro rata to an entity's existing shareholders for a fixed amount of cash, they should be classified as equity regardless of the currency in which the exercise price is denominated. Equity instruments are not marked to market through profit or loss. The ED Classification of Rights Issues is open for comment until 7 September 2009. The IASB plans to issue the final amendment, on an urgent basis, before the end of 2009 with early application permitted. If adopted the amendment will apply retrospectively. The question considered in the ED is in the scope of the Board's comprehensive project on classification of instruments as debt or equity – Financial Instruments with Characteristics of Equity. Click for IASB Press Release (PDF 101k). Discussion at the September 2009 IASB Meeting Staff presented an analysis of comments received on the exposure draft Classification of Rights Issues: proposed amendment to IAS 32 issued in August 2009. The Board discussed the comments, made certain decisions, and directed the staff to proceed to preparing a ballot draft of final amendments to IAS 32. Scope The Board considered the suggestion made by several respondents to expand the scope of the ED to include equity warrants and convertible debt instruments issued in a foreign currency. The Board decided not to expand the scope of the amendments to include convertible debt instruments issued in a foreign currency. In doing so, the Board also clarified that to be within the scope of the proposed amendment, the underlying instrument (the instrument on which the rights are offered) must be an equity instrument in its entirety and that conversion features in financial liabilities are not 'equity instruments'. Warrants for an entity's own equity would be within the scope. Clarification of the term 'rights issues' The Board agreed that the term 'rights issue' should be clarified in the context of the amendments to include 'rights, warrants, options or similar instruments provided to owners on a pro-rata basis'. Several Board members were concerned that the amendment was not conceptually based-and called into question whether the 'pro-rata' component of the rights issue was critical. To some, whether a right was distributed on a pro-rata basis was irrelevant to whether an instrument was a liability; others were worried that without it, strain would be put on the 'fixed for fixed' criteria in IAS 32.11. The chairman of the meeting noted forcefully that the consideration of 'fixed for fixed' belonged in the project on Financial Instruments with Characteristics of Equity. Pro-rata as a key concept The Board agreed that pro-rata should be emphasised. The basis for conclusions would clarify that the amendment is an exception to the 'fixed for fixed' exception because of the embedded foreign currency features. In addition, the basis for conclusions would emphasise that the primary focus of the amendments was transactions with existing owners acting in their capacity as owners. Continuing the previous discussion, the Board challenged the proposed changes, especially in the context of shareholders in jurisdictions in which equity holders would be unable to take up the rights and whether this would taint or even negate the notion of pro-rata to all shareholders. In response to Board members' questions the staff confirmed that, in the case in which a class of equity instruments was denominated in more than one currency (say euro and US dollar) and the rights were offered pro-rata to only the US dollar-denominated shareholders, the rights issue would fall outside the proposed amendment. Existing owners of the same class of equity The Board agreed that the amendment should continue to require that the rights issue be made to all existing owners of a class of non-derivative equity instruments and that it should not require that the rights issue be made to all existing owners of non-derivative equity instruments of the entity. One Board member wanted the amendment to be restricted such that the rights had to be offered to all shareholders of the most residual class of equity only. Others commented that in many multinational companies, there are often more than one class of common shares and that such a restriction might be a 'null set'. However, the staff did admit that by allowing rights to be offered 'by class', diluting other classes of equity was a possibility. Timing The Board agreed that this amendment should be issued even though the Board is discussing related matters in the Financial Instruments with the Characteristics of Equity project. Re-exposure The Board agreed that the triggers for re-exposure were not met. Effective date The Board agreed that the amendment should be effective for annual financial periods beginning on or after 1 February 2010, with earlier application permissible. The Board considered whether it should not require application from 1 January 2010, but noted that it was unlikely that the amendments could be issued in time to allow the 90-day minimum lead time required for endorsement or incorporation in the legal framework required in several IFRS jurisdictions. Indications of dissent Mr. Smith indicated that he would dissent from the amendments on the basis that he considers the scope to be too broad (he would restrict the amendment to rights issues offered pro-rata to the most subordinated class of equity).
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