IAS 32 and IFRS 7: presentation and disclosure

A company raises money. Is the money a debt, a share of ownership, or a bit of both? The answer matters. Debt costs show up as interest in profit or loss. Equity costs, such as dividends, do not.

A bond that can turn into shares, a preference share that must be bought back. A share that the holder can hand back all sit on the line between debt and equity. International Accounting Standard (IAS) 32 decides which side of the line each one is on.

International Financial Reporting Standard (IFRS) 7 then makes the company explain the risks that its financial instruments bring, so that readers can see what the numbers hide.

This topic covers financial assets, financial liabilities and equity, derivatives, the fixed-for-fixed test, puttable instruments, compound instruments, treasury shares, where interest, dividends and gains go, offsetting, distributable profit under Nigerian law, and the IFRS 7 disclosures for significance and for risk. The previous topics covered IFRS 9. The next topic covers the sundry standards.

Key terms in plain English

Syllabus check

IAS 32 and IFRS 7 are examinable under syllabus area B (financial instruments). This topic covers:

• classification of instruments as assets, liabilities or equity, compound instruments and treasury shares;
• offsetting and distributable profit;
• the IFRS 7 disclosures on significance and on risk.

CAMA 2020, dividends and financial instruments

The Companies and Allied Matters Act 2020 (CAMA 2020) requires statements that follow IFRS and give a true and fair view.

Financial assets, liabilities and equity

Financial asset: cash, an equity instrument of another entity, a contractual right to receive cash or another financial asset, or to exchange instruments on favourable terms, or a contract settled in the entity’s own shares that is a derivative not settled by fixed-for-fixed or a non-derivative that gives a variable number of its own shares. Examples: shares in other companies, bonds, receivables and derivatives in an asset position.

Financial liability: an obligation to deliver cash or another financial asset, to exchange instruments on unfavourable terms, or a contract settled in a variable number of the entity’s own shares. Examples: payables, loans, bonds, derivatives in a liability position, redeemable preference shares and obligations to repurchase own shares for cash.

Equity instrument: a residual interest after liabilities. There is no contractual obligation to deliver cash or other assets. Examples: ordinary shares that cannot be put back, irredeemable non-cumulative preference shares with discretionary dividends, and warrants or written call options over a fixed number of own shares for a fixed amount of cash.

Derivatives

A derivative changes in value with an underlying variable, needs little or no initial investment, and is settled at a future date. The common forms are forwards, futures, swaps and options (see the first IFRS 9 topic). Entities use them for hedging, speculation and market access.

Puttable instruments and contingent settlement

An instrument that the holder can put back to the issuer is normally a liability. It is equity only if it meets the strict conditions for puttable instruments (IAS 32 paragraphs 16A and 16B): among others, it gives a pro rata share of net assets on liquidation, it is in the class subordinate to all others, and the issuer has no other obligation to deliver cash.

If settlement depends on an uncertain event outside the control of both parties, the instrument is a liability unless the feature is not genuine or applies only on liquidation (paragraph 25).

Compound instruments

A convertible bond has a debt part (coupons and redemption) and an equity part (the right to convert). At issue:

1. Value the liability by discounting the coupons and redemption at the market rate for a similar non-convertible bond.
2. The equity is the residual: proceeds less the liability.
3. Transaction costs are split in proportion.

The liability then follows amortised cost, with interest at the market rate used in step 1. The equity is not remeasured and the split is never revised for later changes in yields or share prices. On conversion, the liability is derecognised and share capital and premium are credited. On maturity without conversion, the liability is repaid and the equity stays in reserves (it can be transferred within equity).

Treasury shares, interest and dividends

• Treasury shares: the cost of buying back the entity’s own shares is deducted from equity. Gains and losses on sale, reissue or cancellation go directly to equity, never profit or loss or other comprehensive income. The amount held is disclosed.
• Liabilities: interest, dividends, gains and losses are in profit or loss (for example, dividends on redeemable preference shares are a finance cost).
• Equity: distributions, such as ordinary dividends, are debited directly to equity and bypass profit or loss.
• Issue costs of equity: deducted from equity, net of tax relief.

Offsetting

An asset and a liability can be shown net only if the entity (a) currently has a legally enforceable right to set off the recognised amounts, and (b) intends to settle net or to realise the asset and settle the liability simultaneously. The right must not depend on a future event and must apply in the normal course, on default and on insolvency.

If either test fails, show the gross amounts. IFRS 7 also requires disclosure of offsetting.

Distributable profit and group dividend capacity

Under CAMA 2020 a company may pay dividends only from distributable profits (ss. 426(5) and 427). Directors recommend and shareholders approve the final dividend, and the meeting may reduce but not increase it. Interim dividends are allowed if the articles permit. Distributable profits include profits earned through the use of the company’s assets, revenue reserves, and net realised gains on disposal of fixed assets.

A dividend must not be declared if there are reasonable grounds to believe the company cannot pay its debts as they fall due. Share premium and the capital redemption reserve cannot fund a cash dividend (they can fund a bonus issue).

In a group, the legal limit on the dividend to the parent’s shareholders depends on the parent’s own distributable reserves, not on the consolidated retained earnings.

IFRS 7 disclosures

IFRS 7 has two pillars:

Hidden risks are the reason. A UK entity holding a floating-rate, euro-denominated, silver-linked bond from a German issuer carries interest rate risk, currency risk, commodity price risk and issuer credit risk in one asset. The numbers alone would not show this.

Statement of financial position

• Carrying amounts of each category: financial assets and liabilities at fair value through profit or loss, financial assets at amortised cost, financial assets at fair value through other comprehensive income, and financial liabilities at amortised cost.
• Collateral pledged, a reconciliation of the loss allowance by class, defaults and breaches of loan terms, and the fair value of each class beside its carrying amount (unless they are approximately equal).
• The fair value hierarchy levels and a description of each hedge.

Profit or loss and other comprehensive income

Net gains and losses by category, total interest income and expense (effective interest method), fee income and expense, impairment losses by class, and amounts recycled from other comprehensive income.

Risks

The rules in more depth

Why substance, not form

A share that must be bought back for cash at a fixed date is a debt however it is named. The company has promised cash, and the holder’s claim ranks like a lender’s.

Why liability first in a compound instrument

The liability can be valued from the market rate on straight debt, which is observable. Equity has no independent price, so it is the balance.

Why treasury share gains skip profit

A company cannot make a profit or loss by dealing in its own equity. These are transactions with owners.

Why group dividends depend on the parent

Only the parent is the legal entity that pays its shareholders. Profits earned by subsidiaries become available to the parent only when paid up to it as dividends.

Effect on analysis

Moving a hybrid between debt and equity changes gearing and interest cover. Analysts look at the instrument terms, not the label.

Worked examples

1. Present value of principal.
   ₦2,000,000 ÷ 1.09³ = ₦1,544,367.
2. Present value of coupons (₦120,000 a year for three years) = 110,092 + 101,002 + 92,661 = ₦303,755.
3. Liability = ₦1,848,122.
   Equity = ₦2,000,000 − ₦1,848,122 = ₦151,878.
4. Dr cash ₦2,000,000; Cr financial liability ₦1,848,122; Cr equity (conversion option) ₦151,878.
5. Year 1: interest expense = ₦1,848,122 × 9% = ₦166,331.
   Closing liability = ₦1,848,122 + ₦166,331 − ₦120,000 = ₦1,894,453.

1. Coupons.
   ₦250,000 × (0.9259 + 0.8573 + 0.7938) = ₦250,000 × 2.5770 = ₦644,250.
2. Principal.
   ₦5,000,000 × 0.7938 = ₦3,969,000.
3. Liability = ₦4,613,250.
   Equity = ₦5,000,000 − ₦4,613,250 = ₦386,750.

Note: ICAN’s solution for this question shows the present value of the coupons as ₦584,575, which gives a liability of ₦4,553,575 and equity of ₦446,425. The three discount factors add up to 2.5770, so the coupons are worth ₦644,250. Our figures are slightly different from ICAN’s. In the exam, show the factors and their total.

1. Buy-back: Dr treasury shares (a deduction from equity) ₦50,000; Cr cash ₦50,000.
2. Reissue: Dr cash ₦60,000; Cr treasury shares ₦50,000; Cr equity (share premium or other reserve) ₦10,000.
3. The ₦10,000 gain goes to equity and not to profit or loss.

1. Consolidated retained profits.
   ₦400,000 + 80% × (₦300,000 − ₦100,000) = ₦560,000.
2. The most that the parent can legally pay its own shareholders = ₦400,000 (its own distributable profits).
3. If the subsidiary pays a dividend, 80% reaches the parent and becomes distributable by it.

Note: ICAN’s ladder shows ₦9,600 of interest in the three-month to one-year band. That band is nine months, so the interest is ₦80,000k × 12% × 9/12 = ₦7,200k, and our figure is slightly different from ICAN’s. The three-year interest total is ₦28,800k.

1. Without the put, the shares have no obligation to pay cash, so they would be equity.
2. The put is a contingent settlement feature. If delisting is outside Sunbeam’s control, paragraph 25 makes the instrument a liability. If Sunbeam alone controls whether it delists, the feature does not create an obligation.
3. The exception for puttable instruments (paragraph 16A) needs all its conditions, including a pro rata share of net assets on liquidation and being in the most subordinate class. Preference shares with a fixed dividend entitlement may not meet these.
4. ICAN concludes that the shares are equity under paragraph 16A. State the tests, apply them to the facts and give a reasoned conclusion. If equity, dividends are debited to equity and a buy-back is deducted from equity.

How to score full marks

• Classify by substance and state the obligation test and the fixed-for-fixed test.
• For a hybrid, split it: liability first by discounting at the market rate, equity as the residual. Show the factors.
• Give the journals and say where interest, dividends and gains go.
• For offsetting, state both conditions and say if each is met.
• For dividends, use the parent’s distributable profits and cite ss. 426 and 427.
• For IFRS 7, organise by pillar and risk, with narrative and numbers.
• Use undiscounted amounts in the liquidity table.

Common mistakes in the exam

• Classifying by the name of the instrument.
• Valuing the equity first in a compound instrument.
• Revising the split when market rates change.
• Taking gains and losses on treasury shares to profit or loss.
• Offsetting without a legal right or the intention to settle net.
• Using consolidated reserves as the limit on the parent’s dividend.
• Using discounted figures in a liquidity table.
• Writing a list of IFRS 7 headings without explaining the risk.

Quick revision

• Obligation to deliver cash means liability. Residual interest means equity. Own shares: fixed-for-fixed.
• Compound: liability at the market rate for straight debt, equity as the residual, no revision.
• Treasury shares: deduct from equity. Gains and losses in equity.
• Liability costs in profit or loss. Equity distributions in equity.
• Offset: legal right and intention to settle net.
• Dividends: distributable profits of the parent. CAMA 2020 ss. 426(5), 427, 433.
• IFRS 7: significance and risk. Credit, liquidity, market.
• CAMA 2020: ss. 377(1), 378, 184, 385, 404(7).

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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