Classification and measurement (ifrs 9/ias 32) - Equity inst...

Learning Outcomes

By the end of this article, you will be able to classify financial instruments as equity or liability using IAS 32 and IFRS 9, explain and apply the rules for hybrid and compound instruments, recognize the exam significance of the liability-equity distinction, and understand the impact on financial statements and key ratios. You will also be able to analyze practical scenarios commonly seen in SBR exam questions.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand the distinction between equity and financial liabilities, including their initial classification, subsequent measurement, and implications for financial reporting and analysis. Focus your revision on the following syllabus points:

• Explain and apply the definitions of financial assets, financial liabilities, and equity instruments under IAS 32
• Classify financial instruments as equity, liability, or compound in accordance with IAS 32
• Evaluate and apply the initial recognition and measurement requirements for financial instruments under IFRS 9
• Describe and account for compound instruments containing both liability and equity components
• Discuss the impact of classification on financial statements, financial ratios, and key disclosures

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. A company issues 5-year preference shares that are mandatorily redeemable for cash. Should these be accounted for as equity or a liability under IAS 32?
   1. Equity
   2. Liability
   3. Both
   4. Not recognized
2. If a financial instrument gives the holder the right to require the issuer to repay cash at a fixed date, what is the classification in the issuer’s accounts?
   1. Equity
   2. Liability
   3. Compound instrument
   4. None of the above

3. True or False? An instrument that will be settled by issuing a variable number of shares with a total value equal to a fixed amount is an equity instrument.

4. Briefly explain how a convertible bond is accounted for under IAS 32 on initial recognition.

5. When does a compound instrument arise, and what are its typical components?

Introduction

The classification of financial instruments as either equity or financial liabilities is a fundamental element of financial reporting, directly affecting how instruments are measured, presented, and disclosed in financial statements. IAS 32 sets the rules for classification, while IFRS 9 provides guidance on subsequent measurement. Understanding how to correctly classify and explain the implications of complex and hybrid instruments is essential for Strategic Business Reporting—and frequently tested in the exam.

This article focuses on each step in the classification process. It explains the definitions, practical decision rules for common and compound instruments, and the effects of classification on reported profit, equity, and ratios.

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

Classification Principles in Practice

IAS 32 requires that an instrument is classified based on its substance, not just legal form, and on the contractual terms at initial recognition.

Financial Liability

A financial liability arises when an entity has a contractual obligation to:

• Deliver cash or another financial asset to another entity
• Exchange financial assets or liabilities with another party under conditions that are potentially unfavorable to the entity

Key Term: Financial Liability
A contractual obligation to deliver cash or another financial asset to another entity, or to exchange financial instruments under unfavorable conditions.

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

Equity Instrument

An instrument is equity only if there is no contractual obligation to deliver cash or another financial asset, and if settled in the issuer’s own shares, settlement involves issuing a fixed number of shares for a fixed amount of cash (the “fixed-for-fixed” rule).

Applying the Rules

To classify an instrument:

1. Is there a contractual obligation to deliver cash or another asset?
   • If yes: Liability
   • If no: move to step 2
2. Will the instrument, if settled in shares, result in a fixed number of shares being exchanged for a fixed cash amount?
   • If yes: Equity
   • If no: Liability

Key Term: Compound Instrument
A financial instrument that contains both a liability component and an equity component, such as a convertible bond.

Examples of Classification

• Ordinary shares with no mandatory redemption: Equity
• Mandatorily redeemable preference shares: Liability (obligation to repay cash)
• Convertible bond: Compound instrument (contains a liability component and an equity option)

Compound and Hybrid Instruments

Some financial instruments contain both a liability and an equity component.

Worked Example 1.1

A company issues £1 million of 5-year bonds that are convertible into a fixed number of equity shares at the holder’s discretion.

Question: How are these bonds classified and initially measured under IAS 32?

Answer:
The instrument is a compound instrument. The liability component is the present value of the contractual future cash flows, discounted at the market rate for non-convertible debt. The equity component is the residual amount (total proceeds less liability component). Both parts are presented separately in the statement of financial position.

Accounting for Compound Instruments

• Liability component: Measured at the present value of future cash outflows (coupons and principal) discounted at the market rate for similar debt without conversion.
• Equity component: Residual amount after deducting the liability component from the proceeds.

Exam Warning The most common error is failing to split instruments that are convertible into equity at the option of the holder. Always check for both payment obligations and options to settle in equity.

Special Cases: Puttable Instruments and Settlement in Own Shares

Some instruments can appear ambiguous. Two specific rules require attention:

• An instrument is a liability if it can be settled at the holder’s request for cash or another financial asset, even if described as a “share.”
• If the issuer must deliver a variable number of own shares equal to a fixed cash value, it is a liability—not equity.

Worked Example 1.2

An entity issues 5,000 shares, redeemable at the holder’s option for cash equal to their initial subscription price after 3 years. No dividends are payable.

Question: Equity or liability?

Answer:
Because the issuer has a contractual obligation to redeem the shares for cash, these are classified as a financial liability, despite being called “shares.”

Measurement Under IFRS 9

The classification (liability or equity) determined under IAS 32 then drives measurement under IFRS 9:

• Liabilities: subsequently measured at amortised cost or fair value, depending on designation and business model.
• Equity: not subsequently remeasured; changes are reflected in equity.

Key Term: Amortised Cost
The initial amount of a financial liability, adjusted for repayments, plus or minus the cumulative amortisation of any difference between initial amount and maturity amount.

Presentation and Impact

Classification directly affects:

• Where payments appear (interest in profit or loss for liabilities, dividends in equity for equity)
• Reported profit
• Key ratios (gearing/debt ratios, return measures)

Worked Example 1.3

A company issues non-redeemable preference shares, with dividends paid only if declared by directors and no obligation to repay.

Question: Liability or equity?

Answer:
There is no contractual obligation to pay cash or deliver any asset; dividends are paid at the issuer’s discretion. Therefore, the shares are classified as equity.

Disclosure Requirements

IAS 32 and IFRS 7 require entities to explain the basis of classification, nature of contractual obligations, and the split between liability and equity (for compound instruments).

Revision Tip

• In the exam, always use the step-by-step approach to avoid classification errors, especially in scenarios involving hybrids, options, or settlement in own shares.

Summary

Correct classification of instruments as equity, liability, or compound has significant consequences for financial statements and ratios. The distinction is made on contractual terms, not legal form. Apply the rules strictly, consider the substance of the arrangement, and remember to split compound instruments at initial recognition.

Key Point Checklist

This article has covered the following key knowledge points:

• Apply IAS 32/IFRS 9 to classify instruments as financial liability, equity, or compound
• Use the substance-over-form principle for correct classification
• Split compound instruments into liability and equity components on initial recognition
• Account for obligations to deliver variable numbers of shares as liabilities
• Identify the presentation and disclosure consequences of classification decisions
• Understand the measurement requirements following correct classification

Key Terms and Concepts

• Financial Instrument
• Financial Liability
• Equity Instrument
• Compound Instrument
• Amortised Cost