IAS 32 Financial Instruments Presentation: Debt vs Equity Classification

IAS 32 Financial Instruments Presentation: Debt vs Equity Classification

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

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The question sounds simple: is this instrument debt or equity? In practice, it is one of the most commercially significant judgements in financial reporting. Classify a preference share as equity and the company's debt-to-equity ratio looks healthy. Classify it as a financial liability and it looks leveraged. The answer changes interest coverage ratios, credit covenants, and how analysts model the business.

IAS 32 answers this question with one principle: classification follows substance, not legal form. A preference share that pays mandatory dividends and redeems at a fixed date is a liability. A bond that converts to a fixed number of shares is a compound instrument, part debt and part equity. The legal name on the certificate does not determine the accounting. The contractual terms do.

This post covers the core classification principle, financial liabilities versus equity, compound instruments and the split accounting approach, the fixed-for-fixed rule for equity settlement, offsetting, and the Indian context across preference shares, CCDs, CCPS, and startup financing structures.

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The Core Principle: Obligation to Deliver Cash

IAS 32's classification test has one central question: does the issuer have a contractual obligation to deliver cash or another financial asset to the holder?

If yes, the instrument is a financial liability.

If no, and the holder receives only a residual interest in the issuer's net assets, it is an equity instrument.

This sounds clean. The complication is that instruments are designed to blur this line. Legal form says "preference share." Contractual substance says the issuer must pay dividends at 9% per annum and redeem at par after five years. That is a bond. Call it what you like; IAS 32 classifies it as a financial liability.

The classification is determined at initial recognition based on contractual terms. It is not affected by:

The entity's financial position or ability to pay. Whether the issuer actually intends to redeem or pay dividends. Past practices around dividend payments. Regulatory or tax treatment of the instrument.

Only the contractual terms matter. If the contract gives the holder the right to demand cash, or obliges the issuer to deliver cash at a specified time, the instrument is a liability regardless of management's stated intentions.

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Financial Liability vs Equity: The Decision Framework

The Obligation Test

A financial liability exists when the issuer has a contractual obligation to:

Deliver cash or another financial asset to the holder, or exchange financial instruments under conditions that are potentially unfavourable to the issuer.

An equity instrument exists when the contract evidences a residual interest in the assets of the entity after deducting all liabilities. No obligation to deliver cash. The holder simply participates in whatever remains.

Applying the Test: Preference Shares

Preference shares are the most commonly misclassified instrument under Ind AS 32. Indian companies issue preference shares in many forms, and the accounting classification often surprises management who think "share" means equity.

Redeemable preference shares with mandatory redemption: The issuer must pay a fixed amount at a specified date. This is a liability. It does not matter that it is legally a share. The contractual obligation to deliver cash controls.

Preference shares with mandatory fixed dividends: Even if the shares never redeem, a contractual obligation to pay dividends at 9% per annum is an obligation to deliver cash periodically. The instrument is a liability, or at minimum a compound instrument if it also carries residual participation rights.

Preference shares where redemption and dividends are at the issuer's discretion: The issuer can choose whether to redeem and whether to pay dividends. No contractual obligation exists. These are equity. The holder cannot compel cash delivery.

Preference shares where the holder can demand redemption: The holder holds the put option. The issuer cannot avoid the obligation if the holder exercises. This is a liability.

A practical example: an Indian company issues 10,000 preference shares at Rs. 100 each, carrying a 9% cumulative dividend, redeemable at par after five years. Management call this "quasi-equity." Under Ind AS 32, this is a financial liability from day one. The dividends are interest expense in profit or loss, not distributions in the equity section. The redemption amount is principal repayment, not a reduction in equity.

Perpetual Instruments

Perpetual debt instruments, bonds with no maturity date, carry contractual interest payments indefinitely. The interest obligation is a financial liability. The absence of a principal repayment obligation does not make the instrument equity if coupon payments are contractually fixed.

Conversely, a genuinely perpetual instrument where interest is entirely at the issuer's discretion and there is no redemption right for the holder could qualify as equity. These are rare. Most instruments described as "perpetual bonds" carry mandatory coupon obligations and are liabilities.

Indian AT1 bonds (Additional Tier 1 capital instruments) issued by banks are perpetual and carry discretionary coupons. Under IAS 32, instruments where distributions are entirely discretionary and there is no principal repayment obligation can be equity instruments. RBI's regulatory treatment of AT1 instruments as equity capital is broadly aligned with this accounting analysis, though the accounting classification and regulatory capital classification are determined under different frameworks.

Contingent Settlement Provisions

Some instruments require cash settlement only if a specified uncertain future event occurs. IAS 32 addresses this: if the contingency is genuine and not within the issuer's control, the obligation is a financial liability. If the event is entirely within the issuer's control, the obligation can be treated as equity until the event occurs.

An instrument that requires cash settlement "if the company's revenue exceeds Rs. 500 crore" is contingently payable. Whether the revenue target is within management's control matters. If the condition is outside management's control (external market conditions, a regulatory decision), the obligation is a liability from inception.

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Compound Financial Instruments: Split Accounting

A compound financial instrument contains both a liability component and an equity component. The classic example is a convertible bond: a debt instrument that gives the holder the option to convert to equity at maturity. The holder can take cash repayment of principal and interest (the liability element) or shares (the equity element).

IAS 32 requires split accounting: the two components are recognised separately from inception. The financial statements show a liability and an equity component, not a single hybrid entry.

The "With and Without" Method

IAS 32 specifies a single approach for splitting the instrument:

Step 1: Measure the fair value of the liability component first. This equals the present value of contractual cash flows (coupons and principal), discounted at the market rate for a similar instrument without the conversion feature.

Step 2: The equity component is the residual. Total proceeds received minus the liability component.

The equity component is never remeasured after initial recognition. It stays at the amount determined at inception.

Worked Example: Convertible Bond

Tata Capital issues a three-year convertible bond on 1 April 2024:

• Face value and proceeds: Rs. 100 crore
• Coupon rate: 6% per annum, payable annually
• Redemption: at par after three years
• Conversion option: holders may convert each Rs. 1,000 of bond into 50 equity shares at maturity
• Market rate for equivalent non-convertible debt: 9%

Step 1: Measure the liability component

Discount the contractual cash flows at 9%:

Step 2: Equity component

Rs. 100.00 crore (proceeds) minus Rs. 92.40 crore (liability) = Rs. 7.60 crore

Day 1 journal entry:

Dr Cash Rs. 100.00 crore

Cr Financial liability (bond) Rs. 92.40 crore

Cr Equity (conversion option) Rs. 7.60 crore

The liability component is subsequently carried at amortised cost using the 9% effective interest rate (not the 6% coupon). Interest expense in P&L each year is the carrying amount multiplied by 9%. The coupon paid (6% on face) is the cash outflow. The difference accretes the liability toward Rs. 100 crore by maturity.

Year 1 interest:

Opening liability: Rs. 92.40 crore

Interest expense (9%): Rs. 8.32 crore

Coupon paid (6%): Rs. 6.00 crore

Closing liability: Rs. 94.72 crore

Interest expense is Rs. 8.32 crore, not Rs. 6.00 crore. The difference is not a timing effect; it is the cost of carrying a below-market coupon bond that was issued at a discount to the instrument's economic cost.

On conversion:

If all bondholders convert at maturity: the liability carrying amount (approximately Rs. 100 crore after three years of accretion) is derecognised. The equity conversion reserve (Rs. 7.60 crore) is reclassified within equity. Shares are issued. No gain or loss in profit or loss at conversion.

If bondholders do not convert: the bond is redeemed at par. The liability is settled. The equity conversion reserve of Rs. 7.60 crore remains in equity; it does not recycle to P&L.

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The Fixed-for-Fixed Rule

A conversion option in a convertible bond qualifies as equity only if it meets the fixed-for-fixed test: the holder receives a fixed number of shares for a fixed amount of cash.

Fixed number of shares for a fixed cash amount: equity. The issuer knows exactly how many shares it will deliver and for how much. The outcome is determined from inception.

Variable number of shares, or conversion at a variable price linked to future events: the conversion feature fails fixed-for-fixed. It is a derivative liability at FVTPL, not equity.

Indian startup context: convertible notes issued to seed investors often have conversion terms linked to the next funding round valuation, typically "at 20% discount to the Series A price." The number of shares delivered depends on a future event (the Series A price) that is not yet known. This fails fixed-for-fixed. The conversion feature is a derivative. The host debt component is at amortised cost. The derivative is at FVTPL.

This matters for Indian startups preparing financial statements for the first time under Ind AS or raising capital from investors who require IFRS-compliant accounts. What founders call "equity" is often a derivative liability that must be marked to fair value each quarter. Fair value changes hit profit or loss. During a period of rapid valuation growth, a startup can report large derivative losses simply from the appreciation of its own future equity value.

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CCPS and CCDs: The Indian Capital Structure Reality

India's venture capital and private equity ecosystem uses two instruments extensively: CCPS (compulsorily convertible preference shares) and CCDs (compulsorily convertible debentures). The accounting treatment under Ind AS 32 depends on the conversion terms.

CCPS with fixed conversion ratio (equity):

If CCPS convert into a fixed number of equity shares and the conversion is compulsory (the holder cannot demand cash), the instrument is equity under Ind AS 32. No cash obligation exists. The FEMA classification as equity for foreign investment purposes aligns with the accounting classification.

CCPS with variable conversion terms (compound or derivative):

If conversion is at a price determined by a future valuation event, or if CCPS carry a guaranteed return that must be paid regardless of whether dividends are declared, the analysis changes. The guaranteed return element is a liability. The conversion element may fail fixed-for-fixed if the number of shares varies.

CCDs:

Compulsorily convertible debentures are debentures that must convert to equity. Under Ind AS 109, CCDs are compound instruments: the host debt (the debenture carrying a coupon) is a financial liability, and the embedded conversion option is assessed for classification as equity or derivative. If conversion is into a fixed number of shares for fixed consideration, the conversion option is equity and split accounting applies. If conversion terms are variable, the embedded conversion option is a derivative at FVTPL.

The regulatory treatment under FEMA treats CCPS as equity and CCDs as debt requiring compliance with ECB norms if issued to non-residents. The regulatory classification does not determine the accounting classification. Finance teams must keep these two frameworks separate.

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Treasury Shares

When an entity repurchases its own equity instruments, those shares become treasury shares. IAS 32 is clear: treasury shares are not financial assets. They are deducted from equity. No gain or loss is recognised on the purchase, sale, issue, or cancellation of treasury shares.

The cost of treasury shares reduces equity directly. If the entity later resells treasury shares at a price above cost, the excess is a premium credited to equity, not profit or loss. If sold below cost, the deficit reduces equity reserves.

Indian companies repurchasing their own shares under buyback programmes must apply this treatment. Infosys, TCS, and Wipro have all conducted significant share buybacks. Each repurchase reduces equity; the shares held in treasury are shown as a deduction from equity in the statement of financial position.

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Offsetting Financial Assets and Liabilities

IAS 32 permits offset, presenting a net amount on the balance sheet, only when both conditions are met simultaneously:

The entity currently has a legally enforceable right to set off the recognised amounts, and the entity intends either to settle on a net basis or to realise the asset and settle the liability simultaneously.

Both conditions must be present. Intention alone is not sufficient. The right must be legally enforceable today, in the normal course of business, and also in the event of default, insolvency, or bankruptcy of either party.

What Does Not Qualify for Offset

A master netting agreement that allows offset only in the event of default or insolvency does not meet the "currently has" requirement for normal-course offsetting. Many ISDA master agreements fall into this category. The right to set off derivatives under the ISDA agreement is contingent on a future event (default). Under IAS 32, this contingent right is not sufficient for balance sheet offset in normal trading periods.

This is why Indian banks show gross derivative assets and gross derivative liabilities on their balance sheets, even when they have ISDA master netting agreements in place with the same counterparty. The gross presentation reflects the IAS 32 standard. The offsetting disclosures required by IFRS 7 (Ind AS 107) show users the netting arrangements and their effect.

What Qualifies for Offset

A current account deposit and an overdraft facility with the same bank, where the bank agreement gives the entity a current, unconditional right to offset the deposit against the overdraft in all circumstances including insolvency, qualifies for offset. The entity intends to settle on a net basis through regular bank account operations.

A trade receivable from a customer and a trade payable to the same customer do not normally qualify. The right to set off receivables against payables requires a formal legal set-off agreement, not just a commercial relationship. Without the legal right, the gross amounts are presented separately.

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Ind AS 32 vs IAS 32: Key Differences

The alignment between Ind AS 32 and IAS 32 is high. The practical challenges in India arise not from differences in the standards but from the gap between legal form and accounting substance in Indian capital structures, particularly in the NBFC sector, startup ecosystem, and PE-backed companies that use hybrid instruments extensively.

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What Big 4 Auditors Focus On

Preference share classification. Auditors review the terms of all preference shares outstanding, checking for mandatory redemption dates, mandatory dividend obligations, and holder put options. Preference shares are the single most common IAS 32 misclassification in Indian Ind AS financial statements. Companies that issued "redeemable preference shares" to PE investors years ago and classified them as equity need careful scrutiny.

Compound instrument bifurcation. For convertible instruments, auditors verify that split accounting has been applied and that the liability component discount rate reflects the market rate for equivalent non-convertible debt at the instrument's issue date. Using the coupon rate instead of the market rate understates the liability component and overstates equity.

Fixed-for-fixed assessment for startup instruments. For companies with convertible notes, SAFEs, or CCPS with variable conversion terms linked to future valuations, auditors assess whether the conversion feature passes the fixed-for-fixed test. Failing this test converts an equity presentation into a derivative liability at FVTPL, with significant P&L volatility consequences.

Offsetting criteria compliance. Auditors test whether items presented net on the balance sheet actually meet both offsetting conditions. The most common error is offsetting based on management intention alone, without a current legally enforceable right. Master netting agreements that apply only in default are not sufficient.

Treasury share presentation. Auditors verify that treasury shares are deducted from equity, not carried as financial assets. Any gains or losses on reissue of treasury shares must go to equity, not P&L.

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Dip IFRS Exam Angle

IAS 32 classification questions are standard in Dip IFRS and appear in two forms: scenario classification (is this instrument debt or equity?) and compound instrument calculation (split the convertible bond into its components).

Most tested areas:

The liability/equity classification test: given a description of a preference share or convertible instrument, determine whether it is a financial liability, equity, or compound instrument. Apply the contractual obligation test, not the legal form.

Compound instrument split: given a convertible bond with coupon rate, market rate, and term, calculate the liability component (PV of cash flows at market rate) and equity component (residual). Know that equity is the residual, never calculated directly.

Interest expense on compound instruments: after splitting, the liability component accretes using the effective interest rate (the market rate at issue date), not the coupon rate. The P&L interest charge is higher than the coupon cash payment. Know this distinction.

Common traps:

Using the coupon rate to discount the liability component. The coupon rate is not the effective interest rate for a below-market coupon bond. The market rate for equivalent non-convertible debt is the discount rate.

Treating the equity component as remeasurable. The equity component of a compound instrument is set at inception and never remeasured. Later changes in the conversion ratio, share price, or market rates do not affect the equity component.

Classifying all preference shares as equity. Legal form does not determine classification. Mandatory dividends and mandatory redemption are the key triggers for financial liability classification. Know the difference between discretionary and mandatory.

Allowing contingent rights to satisfy the offsetting test. A right that applies only in default is not a "currently enforceable" right for IAS 32 offsetting purposes.

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FAQ

Can a company issue preference shares that are equity under IAS 32?

Yes. If the dividends are entirely at the issuer's discretion and there is no mandatory redemption, the preference shares carry no contractual obligation to deliver cash. They are equity under IAS 32. Most PE-backed preference shares in India do not meet this condition because they carry cumulative dividend rights or mandatory redemption.

Does classification as a liability mean dividends become interest expense?

Yes. If preference shares are classified as financial liabilities, the dividend payments are interest expense in profit or loss, calculated using the effective interest method. They are not distributions in the equity section of the statement of changes in equity.

What is the fixed-for-fixed test and why does it matter?

The fixed-for-fixed test determines whether a settlement in the issuer's own shares is an equity transaction. If the entity delivers a fixed number of shares for a fixed cash amount, the outcome is predetermined and the instrument (or the conversion feature) qualifies as equity. If either the number of shares or the cash amount varies based on future events, the settlement is not fixed-for-fixed and the conversion feature is a derivative.

How is a convertible bond carried after split accounting?

The liability component is carried at amortised cost using the effective interest method. The equity component is not remeasured. On the balance sheet, the liability grows from its initial discounted amount toward face value over the bond's life. Interest expense in P&L exceeds the coupon paid in cash each year.

What happens to the equity conversion reserve if the bond is redeemed without conversion?

The equity component remains in equity. When the bond is redeemed at maturity without conversion, the liability component is settled in cash. The equity conversion reserve stays in equity and is typically transferred to retained earnings within equity. It is never recycled to profit or loss.

Does IAS 32 apply to the holder of a convertible bond or only the issuer?

IAS 32's split accounting applies only to the issuer. The holder applies IFRS 9 to classify and measure the instrument, assessing the SPPI test and business model as with any other financial asset.

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Enroll with Global Fin X

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This is Post 23 of the Global Fin X IFRS Series. Previous: IFRS 7: Financial Instruments Disclosures. Next: Post 24: IAS 32 Compound Instruments, Treasury Shares and Puttable Instruments.