IAS 32 - FINANCIAL INSTRUMENTS - PRESENTATION

OBJECTIVE AND SCOPE

To establish principles for presenting financial instruments as:
1. liabilities or
2. equity and
3. for offsetting
financial assets and
financial liabilities
IAS 32 applies from the perspective of the issuer only, to the
1. classification of financial instrument into

financial assets,

financial liabilities,

equity instruments;
2. classification of related
interest,
dividends,
losses and gains;
3. circumstances in which
financial assets and
financial liabilities should be offset.
Does not apply to equity investments in:

associates;

subsidiaries;

employee benefits;

insurance contracts or

share based payments.

Does not apply to contracts that are for the purpose of the

receipt or delivery of a non-financial item

in accordance with the entitys expected

purchase,
sale or
usage requirements.
DEFINITIONS
A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity.

A financial asset is any asset that is:

a) cash;
b) an equity instrument of another entity; e.g. investment in shares
c) a contractual right
i.
to receive
cash or
another financial asset from another entity; or
ii. to exchange
financial assets or financial liabilities
with another entity
under conditions that are potentially favorable to the entity; or
A financial liability is merely the opposite of financial assets definition
Currency is a medium of exchange and is therefore the basis on which all transactions are
measured and recognized in financial statements. Anything acceptable to the parties to the
contract as a medium of exchange is currency.
Examples of currency includes
Cash, Bearer Saving Certificates, Prize Bonds,
Shares, Debentures / Bonds,
Derivatives
Example of financial instrument:
A deposit of cash with a bank or similar financial institution is a financial asset because it
represents the contractual right of the depositor to obtain cash from the institution or to draw a
cheque or similar instrument against the balance in favor of a creditor in payment of a financial
liability.
Another type of financial instrument is one for which the economic benefit to be received or
given up is a financial asset other than cash.
A chain of contractual rights or contractual obligations meets the definition of a financial
instrument if

it will ultimately lead to the receipt or payment of cash or

to the acquisition or issue of an equity instrument.

For Example, a note payable in bearer saving certificates gives the holder the contractual right to
receive and the issuer the contractual obligation to deliver bearer saving certificate, not cash. The
saving certificates are financial assets because they represent obligations of the issuing
government to pay cash. The note is, therefore, a financial asset of the note holder and a financial
liability of the note issuer.

Common examples of financial instruments are:

Primary instruments
a) trade accounts receivable and payable;
b) notes receivable and payable;
c) loans receivable and payable;
d) bonds receivable and payable :and
e) equity instruments e.g., shares of a company or units of a mutual fund, share
options & warrants
Derivatives financial instruments
a) options;
b) futures;
c) forwards; and
d) swaps
Non-financial assets:
Physical assets such as: Inventories; Property, plant and equipment, Oil, Gold, leased assets, and
Intangible assets such as: Patents and trademarks
Control of such physical and intangible assets creates an opportunity to generate an inflow of
cash or another financial asset, but it does not give rise to a present right to receive cash or
another financial asset.
Assets for which the future economic benefit is the receipt of goods or services such as

prepaid expenses
Non-financial liability
Own equity
Deferred revenue & warranty obligations are not financial liabilities because the
outflow of economic benefits associated with them is the delivery of goods and
services rather than a contractual obligation to pay cash or another financial asset.
Income tax is a statutory liability not contractual.
DEFINITIONS ( Cont)
(d) a contract that will or may be settled in the entitys own equity instruments and is:
i.
a non-derivative for which the entity is or may be obliged to receive a variable
number of the entitys own equity instruments; or
ii.
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 entitys own
equity instruments.

An equity instrument s any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
An entitys obligation to issue or purchase a fixed number of its own equity instruments in
exchange for a fixed amount of cash or another financial asset is an equity instrument of the
entity.
Examples of instruments that will or may be settled in own equity and are classified as equity
instruments of the entity are
An issued (written) call option or warrant that gives the holder the right to purchase a
fixed number of equity instruments of the entity (e.g., 1,000 shares) for a fixed price (e.g.,
$100). If the proceeds from issuing the call option is $9,000, the entity makes this journal
entry:
Dr Cash
9,000
Cr Equity
9,000

A purchased call option that gives the entity the right to repurchase a fixed number of its
own issued equity instruments (e.g., 1,000 shares) for a fixed price (e.g., $100). If the
price for purchasing the call option is $9,000, the entity makes this journal entry:
Dr Equity
9,000
Cr Cash
9,000

A forward contract to sell a fixed number of equity instruments (e.g., 1,000 shares) of the
entity to another entity for a fixed exercise price at a future date (e.g., $100). If the
forward is entered into at a zero fair value, no journal entry is required until settlement of
the transaction.

If, however, there is any variability in the amount of cash or own equity instruments that will be
received or delivered under such a contract (e.g., based on the share price, the price of gold, or
some other variable), the contract is a financial asset or financial liability, as applicable.
Examples of instruments that are classified as financial liabilities are
A contract that requires the entity to deliver as many of the entitys own equity
instruments as are equal in value to $100,000 on a future date

A contract that requires the entity to deliver as many of the entitys own equity
instruments as are equal in value to the value of 100 ounces of gold on a future date

A contract that requires the entity to deliver a fixed number of the entitys own equity
instruments in return for an amount of cash calculated to equal the value of 100 ounces of
gold on a future date

Changes in the fair value of an equity instrument are not recognized in the financial
statements.

If a financial instrument requires the issuer

to repurchase its own issued equity instruments for cash or other financial assets,
there is a financial liability for the present value of the repurchase price (redemption
amount).
The liability is recognized by reclassifying the amount of the liability from equity.
Subsequently, the liability is accounted for under IAS 39.
If it is classified as a financial liability measured at amortized cost, the difference between
the repurchase price and
the present value of the repurchase price
is amortized to profit or loss as an adjustment to interest expense using the effective
interest rate method.
Example
On January 1, 20X7, Entity A enters into a forward contract that requires the entity to repurchase
1,000 shares for $60,000 on December 31, 20X7. No consideration is paid or received at
inception of the contract. The market interest rate is 10%, such that the present value of the
payment is $54,545 [= 60,000/(1 + 10%)]. Therefore, the entity makes this journal entry on
initial recognition to recognize its liability for the repurchase price:
Dr. Equity
54,545
Cr. Liability
54,545
On December 31, 20X7, Entity A makes this entry to recognize the amortization in accordance
with the effective interest method:
Dr. Interest expense 5,455
Cr. Liability
5,455
Finally, on December 31, 20X7, Entity A settles the forward contract and makes this journal
entry:
Dr. Liability
60,000
Cr. Cash
60,000
Case Study 1
Facts
Company A is evaluating whether each of these items is a financial instrument and whether it
should be accounted for under IAS 32:
a) Cash deposited in banks
b) Gold bullion deposited in banks
c) Trade accounts receivable
d) Investments in debt instruments
e) Investments in equity instruments, where Company A does not have significant
influence over the investee
f) Investments in equity instruments, where Company A has significant influence
over the investee
g) Prepaid expenses
h) Finance lease receivables or payables

A derivative is a financial instrument or other contract within the scope of this Standard with all
three of the following characteristics:
a) its value changes in response to the change in the
value or return of
an underlying variable such as an interest rate, commodity price or
security price or index;
b) it requires
no initial net investment or
an initial net investment that is smaller; and
c) it is settled at a future date.
Examples: Options, Futures, Forwards & Swaps.
In a forward contract, one party agrees to buy, and the counterparty to sell, a physical asset or a
security at a specific price on a specific date in the future. If the future price of the asset
increases, the buyer has a gain, and the seller a loss.
Example 1:
You have a forward contract to buy US$100,000 at an exchange rate of Rs./US$ 100 after three
months.
In case the exchange rate at the end of three months rises to Rs./US 105. The conditions are
potentially favorable to you as you will make a gain of Rs. 500,000 and it will be other way
round in case the exchange rate falls to Rs./US 95. (US$100,000 x 5 = Rs. 500,000)
Example 2:
You have a forward contract to sell US$100,000 at an exchange rate of Rs./US$ 100 after three
months.
In case the exchange rate at the end of three months rises to Rs./US 105. The conditions are
potentially unfavorable to you as you will incur a loss of Rs. 500,000 and it will be other way
round in case the exchange rate falls to Rs./US 95.
A futures contract is a forward contract that is standardized and exchange-traded. The main
difference with forwards are that futures are traded in an active secondary market, are regulated,
backed by the clearinghouse, and require a daily settlement of gains and losses e.g., Chicago
Mercantile Exchange (www.cmegroup.com)
A swap is a series of forward contracts. In the simplest swap, on party agrees to pay the floating
rate of interest on some principal amount, and the counterparty agrees to pay a fixed rate of
interest in return. Swaps of different currencies and equity returns are also common.

An option to buy an asset at a particular price is termed a call option. The seller of the option has
an obligation to sell the asset at the agreed-upon price, if the call buyer chooses to exercise the
right to buy the asset.
An option to sell an asset at a particular price is termed a put option. The seller of the option has
an obligation to purchase the asset at the agreed-upon price, if the put buyer chooses to exercise
the right to sell the asset.
SITUATIONS WHEN A CONTRACT TO BUY OR SELL A NON-FINANCIAL ITEM IS
TREATED AS A FINANCIAL INSTRUMENT
a) when, for similar contracts, the entity has a practice of
taking delivery of the underlying and
selling it within a short period after delivery
for the purpose of generating a profit from short-term fluctuations in price or
dealers margin;
b) when the ability to settle net in cash or another financial instrument, or by exchanging
financial instruments, is not explicit in the terms of the contract, but the entity has a
practice of settling similar contracts
net in cash or another financial instrument, or
by exchanging financial instruments
whether with the counterparty, by entering into offsetting contracts or
by selling the contract before its exercise or lapse;
c) when the terms of the contract permit either party to settle it
net in cash or another financial instrument or
by exchanging financial instruments; and
d) when the non-financial item that is the subject of the contract is readily convertible to
cash.
A contract to which (a) or (b) applies is not entered into for the purpose of the receipt or delivery
of the non-financial item in accordance with the entitys expected purchase, sale or usage
requirements, and, accordingly, is within the scope of this Standard.
A written option to buy or sell a non-financial item that can be settled net in cash or another
financial instrument or by exchanging financial instruments, in accordance with paragraph (c) or
(d) is within the scope of this Standard.
A contract that involves the receipt or delivery of physical assets does not give rise to a financial
asset of one party and a financial liability of the other party unless:
any corresponding payment is deferred past the date on which the physical assets
are transferred.
Such is the case with the purchase or sale of goods on trade credit.

Example
If an entity today (e.g., 1/1/X6) enters into a contract to purchase gold at a fixed price (e.g.,
100) at a certain date in the future (e.g., 1/1/X7), the contract would be a financial instrument if
the entity could settle the contract net in cash and the entity does not expect to use the gold in its
business activities. In that case, the contract is sufficiently similar to a derivative financial
instrument that it is appropriate to recognize and measure in accordance with IAS 39.
If, however, the entity enters into a contract to purchase electricity and the purpose is to take
delivery of the electricity in accordance with the entitys expected usage requirements, that
contract would be outside the scope of IAS 39. Such a contract would instead be accounted for as
an executory contract and usually not recognized until one of the parties has performed under the
contract.
MULTIPLE-CHOICE QUESTION
Are there any circumstances when a contract that is not a financial Instrument would be
accounted for as a financial instrument under IAS 32?
a) No. Only financial instruments are accounted for as financial instruments.
b) Yes. Gold, silver, and other precious metals that are readily convertible to cash are
accounted for as financial instruments.
c) Yes. A contract for the future purchase or delivery of a commodity or other nonfinancial
item (e.g., gold, electricity, or gas) generally is accounted for as a financial instrument if
the contract can be settled net.
d) Yes. An entity may designate any nonfinancial asset that can be readily convertible to
cash as a financial instrument.
Case Study 2
Entity A enters into a contract to purchase 5 million pounds of copper for a fixed price at a future
date. Copper is actively traded on the metals exchange and is readily convertible to cash.
Required
Discuss whether this contract falls within the scope of IAS 39.
PRESENTATION
LIABILITIES AND EQUITY
The issuer of a financial instrument shall classify the instrument, or its component parts,
on initial recognition as a financial liability, a financial asset or an equity instrument
in accordance with the;

substance of the contractual arrangement; and

The definitions of a financial liability, a financial asset and an equity instrument.
The substance of a financial instrument, rather than its legal form, governs its classification in
the entitys statement of financial position. Substance and legal form are commonly consistent,
but not always.

MULTIPLE_CHOICE QUESTION
Which of the following statements best describes the principle for classifying an issued
financial instrument as either a financial liability or equity?
(a) Issued instruments are classified as liabilities or equity in accordance with the substance
of the contractual arrangement and the definitions of a financial liability, financial asset,
and an equity instrument.
(b) Issued instruments are classified as liabilities or equity in accordance with the legal form
of the contractual arrangement and the definitions of a financial liability and an equity
instrument.
(c) Issued instruments are classified as liabilities or equity in accordance with managements
designation of the contractual arrangement.
(d) Issued instruments are classified as liabilities or equity in accordance with the risk and
rewards of the contractual arrangement.
Some financial instruments take the legal form of equity but are liabilities in substance and
others may combine features associated with equity instruments and features associated with
financial liabilities.
For example:
a) a preference share that provides for mandatory redemption by the issuer for a fixed or
determinable amount at a fixed or determinable future date, or gives the holder the right
to require the issuer to redeem the instrument at or after a particular date for a fixed or
determinable amount, is a financial liability.
b) open-ended mutual funds, unit trusts, partnerships and some co-operative entities may
provide their unit-holders or members with a right to redeem their interests in the issuer
at any time for cash, which results in the unit-holders or members interests being
classified as financial liabilities.
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.

MULTIPLE_CHOICE QUESTION
Which of the following instruments would not be classified as a financial liability?
a) A preference share that will be redeemed by the issuer for a fixed amount of cash on a
future date (i.e., the entity has an outstanding share that it will repurchase at a future
date).
b) A contract for the delivery of as many of the entitys ordinary shares as are equal in value
to $100,000 on a future date (i.e., the entity will issue a variable number of own shares in
return for cash at a future date).
c) A written call option that gives the holder the right to purchase a fixed number of the
entitys ordinary shares in return for a fixed price (i.e., the entity would issue a fixed
number of own shares in return for cash, if the option is exercised by the holder, at a
future date).
d) An issued perpetual debt instrument (i.e., a debt instrument for which interest will be paid
for all eternity, but the principal will not be repaid).
An Exception To The Definition Of A Financial Liability
An instrument is classified as an equity instrument if it has all the following features:
1. It entitles the holder to a pro rata share of the entitys net assets in the event of the
entitys liquidation.
2. The instrument is in the class of instruments that is subordinate to all other classes of
instruments.
3. All financial instruments in the class of instruments that is subordinate to all other classes
of instruments have identical features.
For example, they must all be puttable, and the formula or other method used to calculate
the repurchase or redemption price is the same for all instruments in that class.
4. Apart from the contractual obligation for the issuer to repurchase or redeem the
instrument for cash or another financial asset, the instrument does not include any
contractual obligation to deliver cash or another financial asset to another entity.
5. The total expected cash flows attributable to the instrument over the life of the instrument
are based substantially on the
profit or loss,
change in the recognized net assets or
change in the fair value of the
recognized and
unrecognized net assets of the entity over the life of the instrument.

Case Study 3
Facts
During 2014, Entity A has issued a number of financial instruments. It is evaluating how each of
these instruments should be presented under IAS 32:
a) A perpetual bond (i.e., a bond that does not have a maturity date) that pays 5% interest
each year
b) A mandatorily redeemable share with a fixed redemption amount (i.e., a share that will be
redeemed by the entity at a future date)
c) A share that is redeemable at the option of the holder for a fixed amount of cash
d) A sold (written) call option that allows the holder to purchase a fixed number of ordinary
shares from Entity A for a fixed amount of cash
Required
For each of the above instruments, discuss whether it should be classified as a financial liability
and, if so, why.
RECLASSIFICATION OF PUTTABLE INSTRUMENT
An entity shall account for the reclassification of an instrument as follows :
(a) It shall reclassify an equity instrument as a financial liability from the date
when the instrument ceases to have any features
the financial liability shall be measured at the instruments fair value at the date
of reclassification.
the entity shall recognize in equity any difference between the carrying value of
the equity instrument and the fair value of the financial liability at the date of
reclassification.
(b) It shall reclassify a financial liability as equity from the date
when the instrument has any features.
an equity instrument shall be measured at the carrying value of the financial
liability at the date of reclassification.
CONTINGENT SETTLEMENT PROVISIONS
A financial instruments settlement may be dependent on the:
1. Occurrence or non-occurrence of uncertain future events, such as
borrowers default in case of financial guarantee; or
2. On the outcome of uncertain circumstances that are beyond the control of both
the issuer and the holder of the instrument, such as

a change in a stock market index,

consumer price index,

interest rate or taxation requirements, or

the issuers future revenues,

net income or debt-to-equity ratio.

The issuer of such an instrument does not have the unconditional right to avoid delivering cash
or another financial asset. Therefore, it is a financial liability of the issuer unless:
(a) the part of the contingent settlement provision that could require settlement in cash or
another financial asset or a financial liability is not genuine;
(b) the issuer can be required to settle the obligation in cash or another financial asset or a
financial liability only in the event of liquidation of the issuer; or
(c) the instrument has all the features and meets the conditions as mentioned for puttable
instrument classified as equity instrument.
By not genuine, means that there is no reasonable expectation that settlement in cash or other
asset will be triggered.
Thus a contract that requires settlement in cash or a variable number of the entitys own shares
only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to
occur is an equity instrument.
Similarly, settlement in a fixed number of an entitys own shares may be contractually precluded
in circumstances that are outside the control of the entity, but if these circumstances have no
genuine possibility of occurring, classification as an equity instrument is appropriate.
SETTLEMENT OPTIONS
When a derivative financial instrument gives one party:
a choice over how it is settled e.g. the issuer or the holder can choose settlement
a) net in cash or
b) 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.
Example:
A share option that the issuer can decide to settle net in cash or by exchanging its own shares for
cash.
COMPOUND FINANCIAL INSTRUMENTS
Some financial instruments have both
1. a liability and
2. 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.

For example, a bond convertible by the holder into a fixed number of ordinary shares of the
entity is a compound financial instrument.

From the perspective of the issuer, such an instrument comprises two components:
a) a financial liability (a contractual arrangement to deliver cash or another financial
asset) and
b) an equity instrument (a call option granting the holder the right, for a specified
period of time, to convert it into a fixed number of ordinary shares of the entity).
Classification of the liability and equity components of a convertible instrument is
not revised as a result of a change in the likelihood that a conversion option will
be exercised,
even when exercise of the option may appear to have become economically
advantageous to some holders.
holders may not always act in the way that might be expected because, for
example, the tax consequences resulting from conversion may differ among
holders.
furthermore, the likelihood of conversion will change from time to time.
the entitys contractual obligation to make future payments remains outstanding
until it is extinguished through conversion, maturity of the instrument or some
other transaction.
The issuer of a bond convertible into ordinary shares first determines the
1. carrying amount of the liability component
by measuring the fair value of a similar liability that does not have an associated
equity component.
2. carrying amount of the equity instrument
is then determined by deducting the fair value of the financial liability from the
fair value of the compound financial instrument as a whole.
MULTIPLE_CHOICE QUESTION
What is the principle of accounting for a compound instrument (e.g., an issued convertible
debt instrument)?
a) The issuer shall classify a compound instrument as either a liability or equity based on an
evaluation of the predominant characteristics of the contractual arrangement.
b) The issuer shall classify the liability and equity components of a compound instrument
separately as financial liabilities, financial assets, or equity instruments.
c) The issuer shall classify a compound instrument as a liability in its entirety, until
converted into equity, unless the equity component is detachable and separately
transferable, in which case the liability and equity components shall be presented
separately.
d) The issuer shall classify a compound instrument as a liability in its entirety, until
converted into equity.

Example:
Assume that Roche Group (DEU) issues 2,000 convertible bonds at the beginning of 2011. The
bonds have a four-year term with a stated rate of interest of 6 percent, and are issued at par with
a face value of 1,000 per bond (the total proceeds received from issuance of the bonds are
2,000,000). Interest is payable annually at December 31. Each bond is convertible into 250
ordinary shares with a par value of 1. The market rate of interest on similar non-convertible
debt is 9 percent.
The liability component of the convertible debt is computed as follows:
0

120,000

120,000

120,000

120,000
2,000,000

i = 9%

Interest
Principal

n=4

The liability component of the convertible debt is computed as follows:

Present value of principal:
2,000,000 x .70843 (n = 4, i = 9%) 1,416,850
Present value of the interest payments:
120,000 x 3.23972 (n = 4, i = 9%) 388,766
Present value of the liability component
1,805,616
The equity component of Roches convertible debt is then computed as follows:
Fair value of convertible debt at date of issuance
2,000,000
Less: Fair value of liability component at date of issuance
1,805,616
Fair value of equity component at date of issuance
194,384
The journal entry to record this transaction is as follows.
Cash
2,000,000
Bonds Payable
Share PremiumConversion Equity

1,805,616
194,384

The liability component of Roches convertible debt issue is recorded as Bonds Payable.

Date
1/1/11
12/31/11
12/31/12
12/31/13
12/31/14

Cash
Paid
120,000
120,000
120,000
120,000

SCHEDULE OF BOND AMORTIZATION

EFFECTIVE-INTEREST METHOD
6% BOND DISCOUNTED AT 9%
Interest
Discount
Expense
Amortized
162,506
166,331
170,501
175,046

42,506
46,331
50,501
55,046

Carrying Amount
of Bonds
1,805,616
1,848,122
1,894,453
1,944,954
2,000,000

The amount of the discount relative to the face value of the bond is amortized at each reporting
period so at maturity, the Bonds Payable account is reported at 2,000,000 (face value). The

equity component of the convertible bond is recorded in the Share PremiumConversion Equity
account and is reported in the equity section of the statement of financial position. Because this
amount is considered part of contributed capital, it does not change over the life of the
convertible.
Repurchase at Maturity: If the bonds are not converted at maturity, Roche makes the following
entry to pay off the convertible debt-holders.
Bonds Payable
2,000,000
Cash
2,000,000
(To record the purchase of bonds at maturity)
Because the carrying value of the bonds equals the face value, there is no gain or loss on
repurchase at maturity. The amount originally allocated to equity of 194,384 either remains in
the Share PremiumConversion Equity account or is transferred to Share PremiumOrdinary.
Transaction costs related to the liability and equity components are allocated in proportion to the
proceeds received from the two components. Use the Share PremiumConversion Equity
account to record the equity component. In practice, there may be considerable variance in the
accounts used to record this component.
a) On conversion of a convertible instrument at maturity the entity
derecognizes the liability component and
recognize it as equity
no gain/loss recognition on conversion at maturity
Conversion of Bonds at Maturity: If the bonds are converted at maturity, Roche makes the
following entry.
Share PremiumConversion Equity
194,384
Bonds Payable
2,000,000
Share CapitalOrdinary
500,000
Share PremiumOrdinary
1,694,384
(To record the conversion of bonds at maturity)
As indicated, Roche records a credit to Share CapitalOrdinary for 500,000 (2,000 bonds x
250 shares x 1 par) and the remainder to Share PremiumOrdinary for 1,694,384. There is no
gain or loss on conversion at maturity. The original amount allocated to equity (194,384) is
transferred to the Share PremiumOrdinary account.
As a result, Roches equity has increased by a total of 2,194,384 through issuance and
conversion of the convertible bonds. This accounting approach is often referred to as the book
value method in that the carrying amount (book value) of the bond and related conversion equity
determines the amount in the ordinary equity accounts.
b) When an entity extinguishes a convertible instrument before maturity i.e. redemption or
repurchase in which original conversion privileges are unchanged, the entity allocates

 the consideration paid and

transaction cost
to liability and equity component at the date of transaction.
The method is same as used for original allocation of debt/equity.
Conversion of Bonds before Maturity: To understand the accounting, we again use the Roche
Group example. Amortization schedule related to Roches convertible bonds is shown below:
Assuming that Roche converts its bonds into ordinary shares on December 31, 2012, Roche
debits the Bonds Payable account for its carrying value of 1,894,453. In addition, Roche credits
Share CapitalOrdinary for 500,000 (2,000 x 250 x 1) and credits Share PremiumOrdinary
for 1,588,837. The entry to record this conversion is as follows.
Share PremiumConversion Equity
194,384
Bonds Payable
1,894,453
Share CapitalOrdinary
500,000
Share PremiumOrdinary
1,588,837
(To record the conversion of bonds before maturity)
There is no gain or loss on conversion before maturity: The original amount allocated to equity
(194,384) is transferred to the Share PremiumOrdinary account.
Repurchase before Maturity: In some cases, companies decide to repurchase the convertible
debt before maturity. The approach used for allocating the amount paid upon repurchase follows
the approach used when the convertible bond was originally issued. That is, Roche determines
the fair value of the liability component of the convertible bonds at December 31, 2012, and then
subtracts this amount from the fair value of the convertible bond issue (including the equity
component) to arrive at the value for the equity. After this allocation is completed:
1. The difference between the consideration allocated to the liability component and the
carrying amount of the liability is recognized as a gain or loss, and
2. The amount of consideration relating to the equity component is recognized (as a
reduction) in equity.
Pertinent information related to this conversion is as follows.
Fair value of the convertible debt (including both liability and equity components), based
on market prices at December 31, 2012, is 1,965,000.
The fair value of the liability component is 1,904,900. This amount is based on
computing the present value of a non-convertible bond with a two-year term (which
corresponds to the shortened time to maturity of the repurchased bonds.)
We first determine the gain or loss on the liability component, as follows:
Present value of liability component at December 31, 2012 (given above)
Carrying value of liability component at December 31, 2012 (per schedule)
Loss on repurchase

1,904,900
(1,894,453)
10,447

Roche has a loss on this repurchase because the value of the debt extinguished is greater than its
carrying amount. To determine any adjustment to the equity, we compute the value of the equity
as follows:
Roche makes the following compound journal entry to record the entire repurchase transaction.
Bonds Payable
1,894,453
Share PremiumConversion Equity
60,100
Loss on Repurchase
10,447
Cash
1,965,000
(To record the repurchase of convertible bonds)
In summary, the repurchase results in a loss related to the liability component and a reduction in
Share PremiumConversion Equity. The remaining balance in Share PremiumConversion
Equity of 134,294 (194,384 - 60,000) is often transferred to Share PremiumOrdinary upon
the repurchase.
c) An entity may amend the terms of a convertible instrument to induce early conversion, for
example by offering a more favorable conversion ratio or paying other additional
consideration in the event of conversion before a specified date. The difference, at the date
the terms are amended, between
i.
the fair value of the consideration the holder receives on conversion of the instrument
under the revised terms and
ii. the fair value of the consideration the holder would have received under the original
terms is
iii. recognized as a loss in profit or loss.
Induced Conversions: Sometimes, the issuer wishes to encourage prompt conversion of its
convertible debt to equity securities in order to reduce interest costs or to improve its debt to
equity ratio. Thus, the issuer may offer some form of additional consideration (such as cash or
ordinary shares), called a sweetener, to induce conversion. The issuing company reports the
sweetener as an expense of the current period. Its amount is the fair value of the additional
securities or other consideration given.
Assume that Helloid, Inc. has outstanding $1,000,000 par value convertible debentures
convertible into 100,000 ordinary shares ($1 par value). Helloid wishes to reduce its annual
interest cost. To do so, Helloid agrees to pay the holders of its convertible debentures an
additional $80,000 if they will convert. Assuming conversion occurs,
Helloid makes the following entry.
Conversion Expense
80,000
Bonds Payable
1,000,000
Share CapitalOrdinary
Share PremiumOrdinary
Cash

100,000
900,000
80,000

Helloid records the additional $80,000 as an expense of the current period and not as a reduction
of equity.
Some argue that the cost of a conversion inducement is a cost of obtaining equity capital. As a
result, they contend that companies should recognize the cost of conversion as a cost of (a
reduction of) the equity capital acquired and not as an expense. However, the IASB indicated
that when an issuer makes an additional payment to encourage conversion, the payment is for a
service (bondholders converting at a given time) and should be reported as an expense.
MULTIPLE_CHOICE QUESTION
How are the proceeds from issuing a compound instrument allocated between the liability
and equity components?
a) First, the liability component is measured at fair value, and then the remainder of the
proceeds is allocated to the equity component.
b) First, the equity component is measured at fair value, and then the remainder of the
proceeds is allocated to the liability component.
c) First, the fair values of both the equity component and the liability component are
estimated. Then the proceeds are allocated to the liability and equity components based
on the relation between the estimated fair values.
d) The equity component is measured at its intrinsic value. The liability component is
measured at the par amount less the intrinsic value of the equity component.
TREASURY SHARES
If an entity :

reacquires its own equity instruments,

those instruments (treasury shares) shall be deducted from equity.

no gain or loss shall be recognized in profit or loss on the

i.
purchase,
ii. sale,
iii. issue or
iv.
cancellation of an entitys own equity instruments.
Such treasury shares may be acquired and held by the entity or by other members of the
consolidated group.
Consideration paid or received shall be recognized directly in equity.
Example
On January 15, 20X5, Entity A issues 100 shares at a price of $50 per share, resulting in total
proceeds of $5,000. It makes this journal entry:
Dr Cash
$5,000
Cr Equity
$5,000

On August 15, 20X5, Entity A reacquires 20 of the shares at a price of $100 per share, resulting
in a total price paid of $2,000. It makes this journal entry:
Dr Equity
$2,000
Cr Cash
$2,000
On December 15, 20X5, Entity A reissues 15 of the 20 shares it reacquired on August 15, 20X5,
at a price of $200 per share, resulting in total proceeds of $3,000. It makes this journal entry:
Dr Cash
$3,000
Cr Equity
$3,000
Case Study 4
Facts
At the beginning of 20X4, the amount of equity is $534,000.
These transactions occur during 20X4:
February 15: Dividends of $10,000 are paid.
March 14: 10,000 shares are sold for $14 per share.
June 6: 2,000 shares are repurchased for $16 per share.
October 8: 2,000 shares previously repurchased are resold for $18 per share.
Profit or loss for the year 20X4 is $103,000.
No other transactions affect the amount of equity during the year.
Required
Indicate the effect of these transactions on the amount of equity and determine the amount of
equity outstanding at the end of the year.
INTEREST, DIVIDENDS, LOSSES AND GAINS
1. Interest, dividends, losses and gains relating to a financial instrument or a component that
is a financial liability shall be recognized as income or expense in profit or loss.
2. Distributions to holders of an equity instrument shall be recognized by the entity directly
in equity.
3. Transaction costs of an equity transaction shall be accounted for as a deduction from
equity e.g., registration and other regulatory fees, amounts paid to legal, accounting and
other professional advisers, printing costs and stamp duties.
4. The costs of an equity transaction that is abandoned are recognized as an expense.
OFFSETTING A FINANCIAL ASSET AND A FINANCIAL LIABILITY
Generally, it is inappropriate to net financial assets and financial liabilities and present only
the net amount in the balance sheet.
Example
Entity A has $120,000 of financial asset that are held for trading and $30,000 of financial
liabilities that are held for trading. It would be inappropriate for Entity A to present only the net
amount of $90,000 as a financial asset. Instead it should present a financial asset of $120,000 and
a financial liability of $30,000.

A financial asset and a financial liability shall be offset and the net amount presented in the
statement of financial position when, and only when, an entity:
a) currently has a legally enforceable right to set off the recognized amounts; and
b) intends either to settle on
a net basis, or
to realize the asset and settle the liability simultaneously.
Offsetting differs from the derecognition.
a) Offsetting does not give rise to recognition of a gain or loss,
b) derecognition of a financial instrument not only results
in the removal of the previously recognized item from the statement of
financial position
but also may result in recognition of a gain or loss.
A right of set-off is a debtors legal right, by contract or otherwise, to settle or otherwise
eliminate all or a portion of an amount due to a creditor by applying against that amount an
amount due from the creditor.
Case Study 5
Facts
Entity A has a legal right to set off cash flows due to Entity B (i.e., payables of Entity A) against
amounts due from Entity B (i.e., receivables of Entity A). Entity A has these payables to Entity
B: $1,000,000 on March 31, $3,000,000 on June 30, and $2,500,000 on October 31. Entity A has
these receivables from Entity B: $500,000 on January 15, $4,000,000 on June 30, and
$1,000,000 on December 15.
Required
Indicate the extent to which Entity A can set off the aforementioned receivables and payables in
its balance sheet, assuming it has an intention to settle offsetting amounts net or simultaneously
on each settlement date.
The conditions set out above are generally not satisfied and offsetting is usually inappropriate
when:
a) several different financial instruments are used to emulate the features of a single
financial instrument (a synthetic instrument);
b) financial assets and financial liabilities arise from financial instruments having the
same primary risk exposure (for example, assets and liabilities within a portfolio
of forward contracts or other derivative instruments) but involve different
counterparties;
c) financial or other assets are pledged as collateral for non-recourse financial
liabilities;
d) financial assets are set aside in trust by a debtor for the purpose of discharging an
obligation without those assets having been accepted by the creditor in settlement
of the obligation (for example, a sinking fund arrangement); or

e) obligations incurred as a result of events giving rise to losses are expected to be

recovered from a third party by virtue of a claim made under an insurance
contract.
An entity that undertakes a number of financial instrument transactions with a single
counterparty may enter into a master netting arrangement with that counterparty. Such an
agreement provides for a single net settlement of all financial instruments covered by the
agreement in the event of default on, or termination of, any one contract. These arrangements are
commonly used by financial institutions to provide protection against loss in the event of
bankruptcy or other circumstances that result in a counterparty being unable to meet its
obligations.
A master netting arrangement commonly creates a right of set-off that becomes enforceable and
affects the realization or settlement of individual financial assets and financial liabilities only
following a specified event of default or in other circumstances not expected to arise in the
normal course of business. A master netting arrangement does not provide a basis for offsetting
unless both of the criteria are satisfied.
Examples-1
An enterprise issues 2,000 convertible bonds at the start of Year 1. The bonds have a three-year
term, and are issued at par with a face value of Rs.1,000 per bond giving total proceeds of
Rs.2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6%. Each
bond is convertible at any time up to maturity into 250 common shares of Rs.1 each.
When the bonds are issued the prevailing market interest rate for similar debt without conversion
options is 9%. The entity has incurred Rs. 100,000 as issuance cost of compound instrument. The
effective rate considering the issuance cost of debt is 11% p.a.
Required: Determine the debt and equity component? Pass necessary double entries for all the three
years? Pass necessary double entries at the maturity date if the investor exercises cash
option or share option?
Example-2
On January 01, 1999 Entity A issued 10% convertible debentures with face value of Rs.
1,000,000 maturing at December 31, 2008. The debenture is convertible into ordinary shares of
entity A at Rs. 25 per share. Interest is payable half yearly in cash. The market interest rate for
non-convertible debenture at the issue date is 11%.
On January 01, 2004, the convertible debenture has a fair value of Rs. 1,100,000. Entity A makes
a tender offer to the holders of the debentures for Rs. 1,100,000, which the holders accepted. At
the date of repurchase entity could have issued non-convertible debt with a five-year term
bearing a coupon rate of 8%.
Required:
Determine the debt and equity component at the issue of loan and what accounting entries
to be passed at the date conversion?

PAST PAPERS
The following information pertains to Crow Textile Mills Limited (CTML) for the year ended 30
June 2012:
On 1 July 2011, 2 million convertible debentures of Rs. 100 each were issued. Each debenture is
convertible into 25 ordinary shares of Rs. 10 each on 30 June 2014. Interest is payable annually
in arrears @ 8% per annum. On the date of issue, market interest rate for similar debt without
conversion option was 11% per annum. However, on account of expenditure of Rs. 4 million,
incurred on issuance of shares, the effective interest rate increased to 11.81%.
Required:- Prepare Journal entries for the year ended 30 June 2012 to record the above
transactions. (Show all necessary calculations)
Solution 1
(a) Yes, cash deposited in a bank is a financial instrument. If an entity deposits cash in a
bank, it is a financial asset of the entity and a financial liability of the bank, because the
bank has a contractual obligation to repay the cash to the entity. It falls within the scope
of IAS 32.
(b) No, gold is not a financial instrument. It is a commodity. It is outside the scope of IAS
32.
(c) Yes, a trade accounts receivable is a financial instrument. Trade accounts receivable is a
financial asset because the holder has a contractual right to receive cash. It falls within the
scope of IAS 32.
(d) Yes, an investment in a debt instrument is a financial instrument. Investments in debt
instruments are financial assets because the investor has a contractual right to receive
cash. It falls within the scope of IAS 32.
(e) Yes, an investment in an equity instrument is a financial instrument. Investments in
equity instruments are financial assets because the investor holds an equity instrument
issued by another entity. It falls within the scope of IAS 32.
(f) While an investment in an equity instrument is a financial instrument (a financial asset),
if the investor has significant influence, joint control, or control over the investee, the
investment generally is scoped out of IAS 32 and instead accounted for as an investment
in an associate, joint venture, or subsidiary.
(g) No, prepaid expenses are not financial instruments because they will not result in the
delivery or exchange of cash or other financial instruments. They are outside the scope of
IAS 32.
(h) Yes, finance lease receivables or payables are financial instruments. They are within the
scope of IAS 32. (However, they are scoped out of IAS 39 except for recognition and
measurement of impairment of finance lease receivables.)
(i) No, deferred revenue does not meet the definition of a financial instrument. Deferred
revenue is outside the scope of IAS 32.
(j) No, deferred taxes do not meet the definition of a financial instrument, because they do
not arise from contractual rights or obligations, but from statutory requirements. They are
outside the scope of IAS 32.
(k) No, provisions do not meet the definition of a financial instrument, because they do not
arise as a result of contractual rights or obligations. They are outside the scope of IAS 32.

(l) Even though an electricity purchase contract does not meet the definition of a financial
instrument, it is included in the scope of IAS 32 (and IAS 39) if it can be settled net in
cash unless it will be settled by delivery to meet the entitys normal purchase, sale, or
usage requirements.
(m) Yes, an issued debt instrument meets the definition of a financial liability. It is within the
scope of IAS 32.
(n) Yes, an issued equity instrument is a financial instrument that falls within the scope of
IAS 32.
However, although an issued equity instrument meets the definition of a financial instrument,
there is a specific scope exception for issued equity instruments in IAS 39.
Solution 2
This contract potentially is within the scope of IAS 39 because it is a contract to buy or sell a
nonfinancial item (copper) and the contract is subject to potential net settlement. Under IAS 39, a
contract is considered to be subject to potential net settlement if the nonfinancial item that will be
delivered is readily convertible to cash. This condition is met in this case because the
nonfinancial item is traded on an active market.
Therefore, the contract is within the scope of IAS 39 unless it is a normal purchase or sale.
There is not sufficient information in the question to determine whether it is a normal purchase
or sale. The contract would be considered to be a normal purchase or sale if the entity intends to
settle the contract by taking delivery of the nonfinancial item and has no history of
Settling net;
Entering into offsetting contracts; or
Selling shortly after delivery in order to generate a profit from short-term fluctuations in
price or dealers margin.
Solution 3
(a) An issued perpetual bond (i.e., a bond that does not have a maturity date) that pays 5%
interest each year should be classified as a financial liability. Because the instrument
contains an obligation to pay interest, it meets the definition of a financial liability.
(b) An issued mandatorily redeemable share (i.e., a share that will be redeemed by the entity at
a future date) with a fixed redemption amount should be classified as a financial liability.
Because the instrument contains an obligation to pay a fixed amount of cash or other
financial assets on redemption of the share, it meets the definition of a financial liability.
(c) An issued share that is redeemable for a fixed amount of cash at the option of the holder
should be classified as a financial liability. Because the entity cannot avoid settlement
through delivery of cash should the holder demand redemption, the share meets the
definition of a financial liability.
(d) A sold (written) call option that allows the holder to purchase a fixed number of ordinary
shares from Entity A for a fixed amount of cash should be classified as equity.

Solution 4
Date
January 1, 20X4
February 15, 20X4
March 14, 20X4
June 6, 20X4
October 8, 20X4
December 31, 20X4
December 31, 20X4

Equity: opening balance

Dividend paid
Issuance of equity
Repurchase of equity
Issuance of equity
Profit or loss
Equity: closing balance

Equity
$534,000
10,000
+140,000
32,000
+36,000
+103,000
$771,000

Solution 5
Entity A can offset the $3,000,000 to be received and paid on June 30 because it has a legal right
and intention to settle that amount net or simultaneously. It cannot offset the payments on
January 15, March 31, October 31, and December 15 or the remaining payment of $1,000,000 on
June 30. Accordingly, ignoring the time value of money, Entity A should present assets of
$2,500,000 and liabilities of $3,500,000.