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has the unconditional right to refuse redemption.
Example
A cooperative bank has issued members’ shares that give members the right to vote and participate in dividend distributions. Members also have the right to
request redemption of the shares for cash. The charter of the cooperative bank states that the entity has the right to refuse redemption at its sole discretion, but
the entity has never refused to redeem members’ shares in the past. Nevertheless, the members’ shares are equity because the entity has the unconditional right
to refuse redemption.
In February 2008, IASB published an amendment to IAS 32 to make a limited exception to the principle that instruments that contain an obligation to deliver cash
or other financial assets always should be classified as financial liabilities. This exception applies to instruments that represent the residual interest in the net assets of
the entity and that meet certain specified conditions. Under this exception, some puttable financial instruments and some financial instruments 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 are classified as equity.
Puttable Financial Instruments and Obligations Arising on Liquidation—Amendments Effective 2009
Effective January 1, 2009, IAS 32 Financial Instruments: Presentation, has been amended to address the classification of (1) puttable financial instruments and (2)
obligations arising only on liquidation, with the objective of providing a “short-term, limited scope amendment” designed to avoid outcomes arising under the general
principles of IAS 32 that were counterintuitive.
Puttable financial instruments. A puttable financial instrument includes an instrument where the issuer of the instrument has the obligation to buy back the
instrument on exercise of the put option by the holder of the instrument.
Example
A Cooperative Society of farmers issued a financial instrument to the constituent farmers. The financial instrument provides to the farmer, in proportion to the
holding, a right in the residual interest of the Society. Also, according to the terms of the instrument, a farmer who held the instrument had the option to “put”
or “sell back” the instrument to the Society for cash. Such an instrument would qualify as a puttable instrument.
Generally, any instrument that results in a contractual obligation to deliver cash or another financial asset would qualify as a financial liability. In the previous
example, by this general definition, the puttable instrument would then qualify as a financial liability since there is an obligation to buy back the instrument for cash
upon exercise of the put option by the holder. However, in this case, the entire equity of the entity (the Cooperative Society in the previous example) would then have
to be reclassified as a liability. This would result in the entity having no equity at all, which the Board concluded was counterintuitive.
To avoid such outcomes, the Board provided a limited-scope amendment allowing such instruments to be classified as equity provided the instruments meet certain
stringent conditions.
Thus, puttable financial instruments are presented as equity only if all four of the following criteria are met:
1. The holder is entitled to a pro rata share of the entity’s net assets on liquidation.
2. The instrument is in the class of instruments that is the most subordinate and all instruments in that class have identical features.
3. The instrument has no other characteristics that would have met the definition of a financial liability.
4. The total expected cash flows attributable to the instrument over its life are based substantially on the profit or loss, the change in the recognized net assets or
the change in the fair value of the recognized and unrecognized net assets of the entity (excluding any effects of the instrument itself).
In addition to the criteria set out in the previous paragraph, the entity must have no other instrument that has terms equivalent to criterion 4 aforementioned, and that
has the effect of substantially restricting or fixing the residual return to the holders of the puttable financial instruments.
Obligations only arising on liquidation. Some financial instruments include a contractual obligation for the issuing entity to delivery to another entity a pro rata
share of its net assets only on liquidation. The obligation arises because liquidation either is certain to occur and outside the control of the entity or is uncertain to occur
but is at the option of the instrument holder.
Example
A Cooperative Society of farmers issued a financial instrument to the constituent farmers. The financial instrument provides to the farmer, a right to receive pro
rata share of net assets in cash in the event of liquidation. The Cooperative Society has been incurring losses in the past and management has taken necessary
steps to liquidate the entity. Since liquidation is now certain to occur, there is an obligation to deliver to another entity a pro rata share of net assets. Such an
obligation would quality as an obligation only arising on liquidation.
The criteria for equity classification for instruments 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 are the same as those relating to puttable instruments except criteria 3 and 4 (previously mentioned) do not apply. Criterion 3 does not apply
because, if there is a component of the instrument that meets the definition of a liability (other than the right at liquidation itself), this will be recognized separately as a
financial liability and the instrument will be presented as a compound instrument, that is, with both liability and equity components. Criterion 4 does not apply because
should any cash flows be paid to the holder of the instrument during the instrument’s life, this will reduce the amount ultimately payable at liquidation.
Split Accounting for Compound Instruments
Sometimes issued nonderivative financial instruments contain both liability and equity elements. In other words, one component of the instrument meets the
definition of a financial liability and another component of the instrument meets the definition of an equity instrument. Such instruments are referred to as compound
instruments. The approach to accounting for compound instruments is to apply split accounting, that is, to present the liability and equity elements separately. IAS 32
provides this principle: The issuer of a nonderivative financial instrument shall evaluate the terms of the financial instrument to determine whether it contains both a
liability and an equity component. Such components shall be classified separately as financial liabilities, financial assets, or equity instruments.
Example