IAS 32 and IFRS 7: Financial instruments presentation and disclosures
Liability or equity, splitting a convertible bond, offsetting and treasury shares (IAS 32), and the risk disclosures of IFRS 7.
ACCA exams this helps with: FR Financial Reporting SBR Strategic Business Reporting See the ACCA map
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What it is: IAS 32 decides whether something a company issues is a liability or equity. IFRS 7 says what to disclose about financial instruments and their risks. (How to measure them is in IFRS 9.)
The key idea: if the company can’t avoid paying cash, it’s a liability, whatever it’s called. A convertible bond is part debt, part equity, so it is split.
Example. Preference shares that must be redeemed in 2030 are a liability, and their dividends are a finance cost.
Key words
- Financial liability
- A contractual obligation to deliver cash or another financial asset, or to exchange financial instruments on potentially unfavourable terms.Example: A bank loan; redeemable preference shares.
- Equity instrument
- A contract showing a residual interest in the assets after deducting all liabilities.Example: Ordinary shares.
- Compound instrument
- An instrument with both a liability and an equity component, which are presented separately.Example: A bond the holder can convert into shares.
- Treasury shares
- A company’s own shares that it has bought back and holds. Deducted from equity; no gain or loss in profit or loss.Example: Buying back 10,000 own shares for £25,000.
- Offsetting
- Showing a financial asset and liability as one net amount. Only allowed with a legally enforceable right and an intention to settle net or simultaneously.Example: A bank account in credit and a loan with the same bank, with a legal right of set-off.
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Liability or equity? (IAS 32)
Substance over legal form: is there a contractual obligation to pay cash that the company can’t avoid?
| Instrument | Classification | Payments go to |
|---|---|---|
| Ordinary shares | Equity | Dividends: equity (SOCIE) |
| Preference shares, redeemable on a fixed date or at the holder’s option | Liability | Dividends: finance cost in P/L |
| Irredeemable preference shares with discretionary dividends | Equity | Dividends: equity |
| Convertible bond | Split: liability + equity | Interest: finance cost on the liability part |
- Interest, dividends, gains and losses on a liability go to profit or loss. Distributions to equity holders go directly to equity.
- Costs of issuing equity are deducted from equity.
- Treasury shares: deducted from equity; no gain or loss in profit or loss when bought, sold or cancelled.
- Offsetting only with a currently legally enforceable right to set off and an intention to settle net or simultaneously.
Splitting a convertible bond
- Liability component = present value of the interest and capital payments, discounted at the market rate for similar debt without the conversion option.
- Equity component = proceeds − liability component. It is not remeasured.
- Then the liability is held at amortised cost: add interest at the market (effective) rate, deduct the cash coupon paid.
Disclosures (IFRS 7)
- Significance of financial instruments for the financial position and performance: carrying amounts by category, fair values, gains and losses, interest income and expense.
- Nature and extent of risks, qualitative (how risks arise and are managed) and quantitative:
- Credit risk: maximum exposure, credit quality, expected credit losses.
- Liquidity risk: a maturity analysis of financial liabilities.
- Market risk (currency, interest rate, other price risk): a sensitivity analysis.
Worked example
On 1 January a company issues 2,000 convertible bonds at £1,000 each, so it receives £2,000,000. Coupon 4% paid annually in arrears (£80,000); redeemable at par after 3 years or convertible into shares. Similar bonds without the conversion option pay 6%.
| Cash flow | £ | 6% factor | Present value £ |
|---|---|---|---|
| Interest, years 1–3 | 80,000 | 2.6730 (annuity) | 213,840 |
| Capital, year 3 | 2,000,000 | 0.8396 | 1,679,200 |
| Liability component | 1,893,040 | ||
| Equity component (2,000,000 − 1,893,040) | 106,960 |
| Liability, year 1 | £ |
|---|---|
| Opening | 1,893,040 |
| Finance cost at 6% | 113,582 |
| Coupon paid at 4% | (80,000) |
| Closing | 1,926,622 |
The finance cost in profit or loss is £113,582, not the £80,000 cash paid. The £106,960 stays in equity.
Practice questions
Type or choose your answers, then press Check answer. Questions with a New numbers button can be repeated with different figures.