Financial instrument is defined by IAS 32 ‘any contract that gives rise to financial asset of one entity and a financial liability or equity instrument of another entity.’ (IAS 32: 11) Financial instruments consist of financial assets, financial liability and equity instruments. Example of equity instruments are ordinary shares. Examples of a financial liability are debentures, loan from another entity and trade payables. One way of distinguishing equity from liability is with preference shares. Irredeemable preference shares are equity because they are never repaid and redeemable preference shares are a financial liability because they are paid back like a loan. To distinguish correctly between equity and liability, firstly if there is a contractual obligation on an entity to deliver cash or a financial asset, this will result in a financial liability. If this is not the case it will result in an equity instrument of another entity.
An example of distinguishing equity and liability is for example an entity issues fixed number of shares to another entity, it will be classified as an equity instrument. However if the number of shares will vary depending on share price, in other words not fixed this will be classified as financial liability. Depending on which entity takes the risk will depend if it’s an equity or liability instrument. If another entity takes the risk it will be classified as equity instrument, whereas if the risk was not on another entity it would be a financial liability. Equity and liability are also distinguished in compound instruments also known as hybrid, this means part equity and part liability. Convertible debt consists of part equity and part debt, these need to be separately accounted for. To separate equity from liability, firstly debt needs to be calculated by working out the net present value of future cash flows. After calculating the debt the remaining value is classified as equity.
The Framework Document for the preparation and presentation of financial statements is used to assist and apply International Accounting Standards. At first the Framework defines equity and liability, as well as explains how to identify an equity or liability with regards to the underlying substance. However the methodology is complaint with the Framework Document to the extent that balance sheets may include items that do not satisfy the definitions of a liability and are not shown as part of equity. ‘Balance sheets drawn up in accordance with current International Accounting Standards may include items that do not satisfy the definitions of an asset or liability and are not shown as part of equity.’ (Framework Document: B1723, 52) This shows that the methodology of equity and liability may not be fully compliant with the Framework Document. To distinguish between equity and liability correctly as well as to be compliant with the Framework Document, a criterion needs to be explained to correctly identify an asset or liability, which is not clearly explained. Without identifying and stating in detail the criterion, equity and liability can be wrongly recognised. This affects users of financial statements, because information in the financial statements can be misleading and misunderstood by users. Exposure drafts set out the Boards proposals for the future framework, for views and comments from the public. The latest exposure draft for financial liabilities is fair value option for financial liabilities issued in May 2010 by the IASB. There are limited changes to the accounting for liabilities. The new proposal applies to entities that choose to measure at fair value, all gains and losses ensuing from changes in the credit risk of a financial liability, known as own credit should be transferred to other comprehensive income. This way any change in own credit will not affect reported profit or loss. ‘effects of changes in a liability’s credit risk should be presented in other comprehensive income’ (Exposure...
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