IAS 32 Compound Instruments, Treasury Shares and Puttable Instruments
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Sai Manikanta Pedamallu
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IAS 32 Compound Instruments, Treasury Shares and Puttable Instruments
By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)
Lead Instructor, Global Fin X | www.globalfinx.in/manikanta
Post 23 covered the core IAS 32 classification principle and the split accounting mechanics for compound instruments at inception. This post goes deeper into three areas that generate the most practical complexity: what happens to a compound instrument after initial recognition, how treasury shares work under IAS 32 and where Indian law diverges from the standard, and the puttable instrument exception that saves mutual funds and partnerships from an accounting result nobody wanted.
These are not obscure edge cases. Convertible bonds get repurchased early, modified, or converted before maturity. Indian companies run buybacks every year. Open-ended mutual funds hold units that are redeemable on demand. Each situation has a specific IAS 32 treatment, and each is examined in Dip IFRS.
Compound Instruments After Initial Recognition
Subsequent Measurement of Each Component
Once a compound instrument is split at inception, the two components live separate lives on the balance sheet.
The liability component follows IFRS 9's amortised cost rules. The effective interest rate established at inception, which is the market rate for equivalent non-convertible debt, drives interest expense each period. The liability accretes from its initial discounted carrying amount toward face value over the instrument's life. Coupon payments reduce the cash balance but do not equal the interest expense charge. The difference is the accretion of the discount.
The equity component is fixed at inception and never remeasured. Share price movements, changes in the conversion ratio's attractiveness, and changes in market interest rates have no effect on the equity component's carrying amount. It sits in equity at the same number recognised on day one until the instrument is converted, redeemed, or otherwise settled.
Deferred Tax on the Liability Component
Compound instruments create a deferred tax liability that many preparers overlook at initial recognition.
When a convertible bond is recognised under IAS 32, the liability component is the present value of contractual cash flows. The equity component is the residual. In most jurisdictions, tax law treats the whole instrument as debt: the full face value is the tax base of the liability. The carrying amount is lower than the tax base because of the discount to present value applied to get the liability component.
This creates a taxable temporary difference: the tax base of the liability exceeds its carrying amount. A deferred tax liability arises.
Worked example: an entity issues a three-year convertible bond with proceeds of Rs. 100 crore. The liability component at initial recognition is Rs. 85 crore. The equity component is Rs. 15 crore. Tax rate is 25%. The tax base of the liability is Rs. 100 crore (the full face value, which tax law treats as debt). Temporary difference: Rs. 15 crore. Deferred tax liability: Rs. 3.75 crore.
IAS 12 paragraph 23 normally prohibits recognition of a deferred tax liability on temporary differences arising on initial recognition that did not arise in a business combination and that did not affect accounting or taxable profit. This is the initial recognition exemption. But it does not apply here. The temporary difference arises from the bifurcation of the equity component, not from initial recognition of the instrument as a whole. The deferred tax liability must be recognised.
The journal entry at initial recognition:
Dr Cash Rs. 100.00 crore
Cr Financial liability (bond) Rs. 85.00 crore
Cr Equity (conversion option) Rs. 15.00 crore
Dr Equity (conversion option) Rs. 3.75 crore
Cr Deferred tax liability Rs. 3.75 crore
The net equity component after the deferred tax adjustment is Rs. 11.25 crore. The deferred tax liability unwinds over the life of the bond as the liability accretes to face value.
This deferred tax treatment catches people out in Dip IFRS exams. Know that the IAS 12 initial recognition exemption does not apply to compound instruments.
Conversion at Maturity
When bondholders choose to convert at maturity, the accounting is clean. The liability carrying amount at maturity will have accreted back to face value (approximately, after the discount has unwound through three years of effective interest). The entries on conversion:
Dr Financial liability Rs. 100 crore (carrying amount at maturity)
Dr Equity conversion reserve Rs. 11.25 crore (the remaining equity component after deferred tax)
Cr Share capital and premium Rs. 111.25 crore
No gain or loss is recognised in profit or loss. Conversion is an equity transaction, reclassifying amounts already recognised between liability and equity.
Early Conversion (Before Maturity)
IAS 32 does not specify the procedure for conversion before maturity, but the accepted treatment is identical in principle. On the conversion date, the liability carrying amount at that date (accreted up to the conversion date using the EIR) is derecognised and transferred to equity. The equity conversion reserve is also transferred to equity (share capital and premium). No gain or loss.
The carrying amount of the liability at early conversion will be less than face value because the accretion is incomplete. For example, if the bond in the example above converts at the end of Year 2 when the liability carrying amount is Rs. 94 crore, the entry is:
Dr Financial liability Rs. 94 crore
Dr Equity conversion reserve Rs. 11.25 crore
Cr Share capital and premium Rs. 105.25 crore
Redemption Without Conversion
If bondholders do not convert and the bond is redeemed at par, the liability is settled in cash. The equity conversion reserve stays in equity permanently. It does not recycle to profit or loss. Typically it is transferred to retained earnings within equity via a reserves transfer, but no P&L impact arises.
This is a critical exam point. The equity component of a compound instrument that is ultimately redeemed without conversion is not a loss. It remains in equity. The cost to the entity was the higher effective interest rate paid on the liability component throughout the instrument's life, which correctly reflected the below-market coupon offset by the option value given to holders.
Early Redemption or Repurchase of the Whole Instrument
When an entity redeems a convertible bond early while the conversion option still exists, IAS 32 requires allocation of the consideration paid to the liability and equity components at the transaction date.
Step 1: Determine the fair value of the liability component at the repurchase date. This is the present value of remaining cash flows discounted at the current market rate for equivalent non-convertible debt.
Step 2: The consideration allocated to equity is the total consideration paid minus the fair value of the liability component.
Step 3: The difference between the fair value of the liability component and its carrying amount at the repurchase date is a gain or loss on extinguishment, recognised in profit or loss.
Step 4: The consideration allocated to equity is compared to the carrying amount of the equity component. Any difference is recognised directly in equity, not P&L.
This allocation means that gains and losses on early repurchase of compound instruments split between P&L (the liability portion) and equity (the equity portion). Missing this allocation and routing everything through P&L is a common error.
Modification of Compound Instruments
When the terms of a convertible bond change, for example the conversion ratio is adjusted or the coupon is modified, the accounting depends on whether the modification results in extinguishment.
If the modified instrument is substantially different from the original (applying the IFRS 9 10% test and qualitative assessment), the original instrument is derecognised and the new instrument is recognised. The new instrument is split afresh under IAS 32 based on terms at the modification date.
If the modification is not substantial, the original instrument continues, adjusted for any consideration paid or received and with the EIR recalculated if necessary.
The modification of the conversion terms themselves requires particular care. Changing the conversion ratio or conversion price changes the value allocated to the equity component. A modification that makes conversion more attractive (lowering the conversion price or increasing the ratio) increases the value of the equity component. The incremental fair value given to equity holders on modification is recognised as an expense, typically reported as finance cost or as a component of equity depending on the nature.
Transaction Costs on Compound Instruments
Transaction costs incurred on issuing a compound instrument are allocated between the liability and equity components in proportion to the allocation of proceeds.
If the liability component receives 85% of proceeds and equity 15%, transaction costs are 85% charged to the liability component (increasing the EIR) and 15% charged to the equity component (reducing the equity carrying amount).
For the equity portion, transaction costs reduce equity directly. For the liability portion, they reduce the initial carrying amount of the liability and are amortised over the instrument's life through the effective interest rate mechanism. The EIR is recalculated after adjusting for transaction costs, making it slightly higher than the unadjusted rate.
Foreign Currency Convertible Bonds
Foreign currency convertible bonds issued by Indian companies, common in the mid-2000s infrastructure and real estate boom, add a layer of complexity. If a convertible bond is denominated in a currency other than the issuer's functional currency, the conversion option fails the fixed-for-fixed test.
The reason: the holder can convert a fixed number of USD-denominated bonds into a fixed number of Indian equity shares. But from the issuer's perspective, the number of rupees received on conversion is not fixed, because the USD-denominated conversion price translates at the prevailing exchange rate. The amount of cash (in functional currency terms) varies. Fixed-for-fixed fails.
The conversion option in a foreign currency convertible bond is a derivative liability at FVTPL, not equity. The host debt is at amortised cost. The derivative is marked to market each period, creating P&L volatility.
Several Indian infrastructure companies that issued FCCBs during 2005 to 2008 and then transitioned to Ind AS had to reclassify conversion features from equity to derivative liabilities on transition. The P&L effect of marking those derivatives to fair value in subsequent periods was material and unwelcome.
Treasury Shares
IAS 32 Treatment
Under IAS 32, when an entity reacquires its own equity instruments, the repurchased shares are treasury shares. They are deducted from equity. No financial asset is recognised. No gain or loss is recognised at the time of purchase.
If treasury shares are subsequently reissued at a price above their cost, the excess goes to a share premium or additional paid-in capital account within equity. Never to profit or loss. If reissued below cost, the deficit reduces equity reserves.
The principle is consistent: transactions in an entity's own equity instruments are equity transactions. The income statement is not affected.
The Indian Complication: Companies Act 2013
Indian companies face a structural divergence from IAS 32 on this point. Under Section 68 of the Companies Act 2013, shares bought back by an Indian company must be extinguished immediately. The company cannot hold its own shares as treasury shares. Buyback reduces share capital and the shares are cancelled on the same day.
This means the treasury share concept under IAS 32, where shares are held as a deduction from equity and potentially reissued later, does not apply in India in the same way. TCS, Infosys, and Wipro have all conducted large buybacks. Under Ind AS 32, the accounting is a direct reduction in equity: the shares are cancelled, the capital reduction amount comes from retained earnings or the securities premium account, and no treasury share asset is ever recognised.
The Ind AS 32 note on buybacks for Indian companies therefore shows an equity reduction rather than a treasury share deduction line. The practical outcome is the same as IAS 32 treasury share accounting in terms of balance sheet presentation (equity is reduced), but the mechanism is different. No shares are held and no subsequent reissuance is possible.
There is one exception. Shares held in connection with employee share option plans through a trust structure may be presented as treasury shares under Ind AS 32 if the entity is considered to control the trust and the shares are held for the purpose of satisfying future share-based payment awards. ESOP trusts in Indian companies are the primary context where treasury share presentation arises.
Costs of Equity Transactions
Costs directly attributable to issuing or buying back equity instruments are charged to equity, not profit or loss. Legal fees, underwriting commissions, and stamp duties on a share issuance or buyback are equity transaction costs under IAS 32.
Costs that are not directly attributable, management time, general overhead, IPO roadshow costs that would have been incurred anyway, are not equity transaction costs and are expensed.
Puttable Instruments: The 2008 Exception
The Problem That Created the Exception
A puttable instrument gives the holder the right to sell the instrument back to the issuer for cash. Under the general IAS 32 principle, this is a financial liability: the issuer has a contractual obligation to deliver cash when the holder exercises the put.
Applied mechanically to open-ended mutual funds, this produces an absurd result. Every unit in a mutual fund is puttable: unitholders can redeem for cash at any time. Classifying all units as financial liabilities would mean the fund has no equity. Its statement of financial position would show only liabilities and assets, with zero equity. The fund's own "profit" each year would be interest expense on its liabilities.
The same problem arises for cooperative entities, whose members can typically demand their shares back, and for partnership interests where partners can withdraw their capital.
In 2008, the IASB introduced paragraphs 16A to 16D into IAS 32 to address this. The exception is narrow. It classifies certain puttable instruments as equity, provided they meet specific conditions.
The Five Conditions for Puttable Equity Classification
For a puttable instrument to be classified as equity under the 2008 exception, all five conditions must be satisfied:
Condition 1: The instrument entitles the holder to a pro rata share of the entity's net assets on liquidation. The payout is not a fixed amount; it tracks the residual value of the entity.
Condition 2: The instrument is in the most subordinate class of instruments. If the entity has ordinary shares outstanding, the puttable instruments cannot be equity under this exception unless they rank equally with those ordinary shares on liquidation.
Condition 3: All instruments in the most subordinate class have identical features. Every instrument in the class must have the same right to a pro rata share of net assets, the same redemption terms, the same priority.
Condition 4: The instrument carries no contractual obligation to deliver cash or another financial asset other than the put right itself. There must be no mandatory dividend, no coupon, no obligation to redeem at a fixed amount.
Condition 5: The total expected cash flows attributable to the instrument over its life are based substantially on profit or loss, change in recognised net assets, or change in fair value of recognised and unrecognised net assets. The instrument participates in the performance of the entity, not just receives fixed returns.
All five conditions must be met simultaneously. If any one fails, the instrument is a financial liability under the general principle.
Practical Application: Indian Mutual Funds
Indian mutual fund units are redeemable on demand (open-ended funds) or at the end of the fund's life (close-ended funds). Under Ind AS 32, open-ended mutual fund units meet the puttable instrument conditions and are classified as financial liabilities in the fund's financial statements.
This is why an SEBI-registered open-ended mutual fund presents its financial statements showing "Net Assets Attributable to Unitholders" as a liability, not equity. The units are puttable liabilities. The standard permits alternative labelling, "net assets attributable to unitholders" rather than "equity," to preserve the economic communication, but the classification is still liability.
For close-ended funds with a fixed redemption date, the analysis may differ. If the fund's units have a maturity structure and cannot be put back before maturity, the units may be financial liabilities for a different reason (contractual obligation to pay on maturity) but the puttable instrument exception does not apply.
Partnership Interests
A partner's interest in a partnership that can be surrendered at any time for a cash payment equal to the partner's share of net assets meets the puttable instrument conditions. The partnership interest is equity under the exception if the other four conditions are also satisfied.
This matters for Indian limited liability partnerships and professional service firms that report under Ind AS. Partner capital is equity under the puttable instrument exception if it represents a residual interest in net assets and the other conditions hold.
Dividends, Interest, and Gains on Financial Instruments
IAS 32 has one more presentation rule that is straightforward but frequently applied incorrectly in practice.
Distributions on instruments classified as financial liabilities are interest expense in profit or loss. The label "dividend" in a legal document does not change this. If the preference share is a liability, the "dividend" paid on it is interest expense, shown in the income statement above the line, not as an appropriation of profit.
Distributions on instruments classified as equity are recognised directly in equity. They never touch profit or loss. A genuine ordinary dividend declared by TCS is a charge to retained earnings in the statement of changes in equity, not an expense in the income statement.
Gains and losses on repurchase of financial liabilities go to profit or loss. Gains and losses on transactions in equity instruments, including treasury share transactions, go to equity.
The practical implication: a company that has misclassified redeemable preference shares as equity has also been misclassifying the "dividends" as equity appropriations rather than interest expense. The restatement affects both the balance sheet (liability classification) and the income statement (interest expense recognition) for every period the preference shares were outstanding.
Ind AS 32 vs IAS 32: Differences on This Post's Topics
| Area | IAS 32 | Ind AS 32 |
|---|---|---|
| Compound instrument split accounting | Required | Same |
| Deferred tax on compound instruments | IAS 12 initial recognition exemption does not apply | Same |
| Treasury shares | Deducted from equity; can be held and reissued | Same in principle; Companies Act 2013 requires immediate cancellation on buyback, so treasury shares arise only through ESOP trust structures |
| FCCB conversion option classification | Derivative liability if conversion price in foreign currency | Same; several Indian companies restated on transition to Ind AS |
| Puttable instrument exception | Available for mutual funds, cooperatives, partnerships | Same; Indian mutual fund units are liabilities under Ind AS 32 |
| Dividends on liability-classified instruments | Interest expense in P&L | Same |
| Costs of equity transactions | Charged to equity | Same; management must separate direct issue costs from general costs |
What Big 4 Auditors Focus On
Deferred tax on compound instruments. Auditors verify that a deferred tax liability has been recognised at the time of issuing convertible instruments, using the correct temporary difference calculation. Overlooking this step produces overstatement of equity and understatement of deferred tax.
EIR accuracy after transaction cost allocation. Where an entity incurs transaction costs on a compound instrument, auditors test whether costs have been allocated between liability and equity components in proportion to proceeds, and whether the EIR has been recalculated to absorb the liability portion of those costs.
FCCB derivative identification. For Indian companies with foreign currency convertible bonds, auditors test whether conversion options failing fixed-for-fixed have been separated as derivative liabilities and whether those derivatives are being marked to market each period.
Puttable instrument classification completeness. For fund managers, cooperative societies, and partnership structures, auditors verify whether all puttable instruments have been identified and whether the five conditions for equity classification under the 2008 exception have been assessed and documented.
Early repurchase allocation. When an entity repurchases a convertible instrument before maturity, auditors test whether the consideration has been allocated between liability and equity components, with only the liability portion's gain or loss going through P&L.
Dividend reclassification on liability instruments. Where preference shares are reclassified from equity to liability (a common correction in Indian companies transitioning to Ind AS or being audited for the first time under Ind AS 32), auditors ensure that prior-period comparatives are restated and that the dividends previously treated as equity appropriations are restated as interest expense.
Dip IFRS Exam Angle
Post 24 material appears in the more complex IAS 32 exam questions, usually as multi-part calculations testing the full life of a compound instrument.
Most tested areas:
Deferred tax on initial recognition of a compound instrument: given the split, the tax rate, and the tax treatment in the jurisdiction (instrument treated as debt for tax purposes), calculate the deferred tax liability and adjust the equity component.
EIR table for the liability component: given the initial carrying amount, the EIR, and the coupon paid, build the amortised cost table showing interest expense, coupon paid, and closing carrying amount for each year.
Conversion and redemption accounting: on conversion, derecognise the liability and reclassify the equity component to share capital with no P&L impact. On redemption without conversion, leave the equity component in equity.
Puttable instrument conditions: given a description of a mutual fund or partnership, assess whether all five conditions for equity classification under the 2008 exception are met.
Common traps:
Recognising a gain or loss on conversion of a compound instrument. Conversion is not a P&L event. No gain or loss arises when bondholders exercise their conversion right.
Applying the IAS 12 initial recognition exemption to the deferred tax on a compound instrument. It does not apply. The exemption covers initial recognition of the whole instrument; the deferred tax here arises from bifurcation of the equity component.
Using the coupon rate as the EIR for the amortised cost table. The EIR is the market rate for equivalent non-convertible debt at issue date, not the coupon on the instrument. The coupon is lower than the EIR by design.
Forgetting that the equity component is residual and fixed: it cannot be revalued. If a question changes the share price or market interest rate and asks for the equity component, the answer remains the original split amount.
FAQ
What is the equity component in a compound instrument really representing?
It is the value of the conversion option given to bondholders: the right to convert debt into equity at a pre-agreed ratio. It compensates the entity for issuing the bond at a below-market coupon. At inception it equals the difference between the proceeds received and the present value of the contractual cash flows at market rates.
Why does the initial recognition IAS 12 exemption not apply to compound instruments?
The exemption in IAS 12 paragraph 15 applies when an asset or liability is first recognised and neither accounting nor taxable profit is affected. For compound instruments, the bifurcation creates a difference between the accounting carrying amount of the liability and its tax base. That difference arises specifically because of the IAS 32 bifurcation requirement. The exemption was never designed to shelter this type of temporary difference.
If all units in an open-ended mutual fund are financial liabilities, does the fund have any equity?
Usually no. Open-ended mutual funds that have no instruments other than puttable units have no equity. The fund's financial statements show assets financed entirely by the "net assets attributable to unitholders" liability. This is mathematically accurate and reflects that unitholders bear all residual risk.
Can Indian companies hold treasury shares through ESOP trusts?
Yes. Where an ESOP trust purchases the company's shares to satisfy future equity award obligations and the company controls the trust, those shares are treated as treasury shares under Ind AS 32. They are deducted from equity. The trust is consolidated into the company's financial statements under Ind AS 110.
How does a modification that makes conversion more attractive affect the compound instrument?
If the conversion terms are changed to benefit holders (lower conversion price or higher ratio), the incremental fair value of the equity component is recognised. Typically this is treated as an additional finance cost or a charge to equity, depending on the nature of the modification and whether it is substantial enough to trigger extinguishment accounting.
What happens to the equity conversion reserve when a convertible bond is redeemed but never converted?
The equity component stays in equity permanently. On redemption, the liability carrying amount is settled in cash. The equity conversion reserve is typically transferred to retained earnings within equity via a journal entry that does not touch P&L.
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This is Post 24 of the Global Fin X IFRS Series. Previous: IAS 32: Debt vs Equity Classification. Next: Post 25: IFRS 13 Fair Value Measurement: Definition, Scope and the Three Approaches.