Accounting For Nancial Instruments With Characteristics of Debt and Equity: Nding A Way Forward

Accounting & Finance
Accounting for financial instruments with characteristics

of debt and equity: finding a way forward
Neil Farghera, Baljit K. Sidhub, Ann Tarcac, Warrick van Zylc

a
Research School of Accounting, ANU College of Business and Economics, Australian National
University, Canberra, ACT, Australia
b
The University of Sydney Business School, The University of Sydney, Sydney, NSW, Australia
c
Accounting and Finance, UWA Business School, University of Western Australia, Crawley,
WA, Australia
Abstract
Accounting for compound financial instruments, that is those with character-

istics of both debt and equity, has challenged accounting standard setters for
decades. The principles developed to distinguish liabilities and equity and the
application of these principles in IAS 32 have been widely criticised. In 2016–
2017, the IASB was engaged in a project to improve IAS 32. Our study presents
research that is relevant to the issues faced by standard setters, related to
improving the definitions and enhancing presentation and disclosure of
liabilities and equity. We discuss studies investigating the effects of the
accounting classification requirements on firms’ financing choices and on users’
decision-making, to examine the question, ‘Does the distinction matter?’ We
then explore various approaches that may be pursued by the standard setters to
improve accounting in this area and identify areas for future research.
Key words: Compound instruments; Equity; Hybrid; IAS 32; Liabilities
JEL classification: M41, M48
doi: 10.1111/acfi.12280
We are grateful to Anne Bean, Michael Bradbury, Kimberley Crook, Jo-Ann Suchard,
Phil Hancock, Kris Peach, Katherine Schipper, Marc Smit, Shaun Steenkamp and an
anonymous reviewer for helpful comments. We appreciate the feedback from partic-
ipants at the AASB Research Forum at the University of Technology Sydney,
November 2016, and the Universities of Western Australia and Queensland Accounting
and Finance Forum, December 2016. This work was completed while Professor Sidhu
was at the UNSW Business School, UNSW Sydney.
Please address correspondence to Neil Fargher via email: neil.fargher@anu.edu.au
© 2018 Accounting and Finance Association of Australia and New Zealand

2 N. Fargher et al./Accounting & Finance
1. Introduction
Distinguishing between the elements of liabilities and equity is a fundamental

accounting issue, which affects classification, measurement and presentation of
items in the financial statements. The International Accounting Standards
Board’s (IASB) Conceptual Framework for Financial Reporting (IASB, 2010a)
(hereafter Framework) provides definitions of these elements. However, with
equity defined as a residual, the Framework provides only limited guidance for
the classification of a transaction or event as representing a liability or equity.
In addition, developments in the nature and complexity of compound financial
instruments have made the traditional dichotomous classification even more
challenging.1
The underlying problem is that compound financial instruments have the
characteristics of both liabilities and equity. International Accounting
Standard 32 Financial Instruments: Presentation (IAS 32) (IASB, 2003)
requires a compound financial instrument to be classified into its liabil-
ity, asset and equity components as at the date of issue and reported
thereafter in these predetermined historical components. The initial
classification of a financial instrument as a liability or equity (or into
components) determines how it is measured and whether interest, dividends
or changes in value relating to that instrument are recognised as income or
expense.
The principles and application of IAS 32 have been widely criticised. In
2008, the IASB’s Discussion Paper on financial instruments with the
characteristics of equity stated that there were two broad classes of criticisms
of the approach in IAS 32 (IASB, 2008): first, the difficulties in applying the
principles in IAS 32, and second, whether the application of those principles
results in an appropriate distinction between equity instruments and
nonequity instruments (IASB, 2008, para 15). Critics claimed that the
application of IAS 32 resulted in inconsistent accounting in some situations
or provided information that was not relevant or understandable (IASB,
2008, paras 27, 29). Proactive Accounting Activities in Europe (PAAinE)
(2008, para 1.3)2 stated that the distinction between equity and liability ‘may
have become an artificial construct rather than a faithful representation of
1
The issue is fundamental and long-standing. An early article (Thom, 1927) asked what
information should be shown on the balance sheet for preferred stock. The answer
proposed revolved around dividend entitlements, convertibility, assets and voting
power. Ford (1969, p. 818) referred to accounting problems due to the ‘increasing usage
of convertible securities’ in the 1960s.
2
PAAinE is an initiative of the European Financial Reporting Advisory Group
(EFRAG) and European standard setters, which intends to influence development of
International Financial Reporting Standards (IFRS).

N. Fargher et al./Accounting & Finance 3
empirical capital structures’. Relating to the application of IAS 32, the IASB
has received considerable feedback about several specific areas of difficulty in
applying the standard.3
Consequently, standard setters face several challenges. Some have argued
that the principles of IAS 32 are clear, but do not result in useful information
(IASB, 2014b). In this vein, Botosan et al. (2005) questioned whether one
approach to distinguishing debt from equity can meet the purposes of all users,
when users differ in their information needs (e.g. related to solvency risk
compared to equity valuation). The IASB noted that some constituents
question the principles used to distinguish between liabilities and equity and the
resulting accounting (2014b).
Plans to modify and improve IAS 32 result from a number of issues. They
include the following: Does the standard have underlying principles for
distinguishing between debt and equity? How are the principles (or other
guidance) applied? Does the application of the principles result in an
appropriate distinction between equity and nonequity instruments? and, if
not, how can the principles and application be improved?4
To inform the debate, our study covers the following material. First, we
identify the guidance for distinguishing debt and equity and discuss problems in
practice arising from current standards. Next, we turn to the academic
literature on the topic to find evidence, which may be relevant to answering
these questions. Subsequently, we review possible future approaches available
to standard setters when modifying IAS 32, to promote discussion and
evaluation of alternative courses of action. We also discuss the current
initiatives of the IASB and the extent to which they address the issues raised in
the literature and our study.
Considering the question ‘does classification matter?’ we conclude that the
answer is in the affirmative. The literature indicates that the choice of financing
structure and the classification of instruments as debt or equity is important to
companies and to other stakeholders. Studies also show that classification can
affect users’ decision-making and outcomes in capital markets. The research
supports the IASB’s interest in this topic. However, there is a dearth of
academic research that can directly assist the IASB’s decision-making
regarding the definitions of liabilities and equity and the classification of
3
They include the following: interpreting the ‘fixed-for-fixed’ condition; accounting for
convertible debt; identifying a contractual obligation; contingent settlement conditions;
reassessment of classification; and accounting for grossed-up dividends (IASB, 2014b,
paras 21–44).
4
When explaining the criticisms of IAS 32, the IASB’s 2008 Discussion Paper states that
concerns related to how the principles should be applied and whether the application of
those principles results in an appropriate distinction between equity and nonequity
instruments (IASB, 2008, para 15).

compound instruments. Therefore, we also identify areas where further

research would be beneficial.
We conclude from the literature that a straightforward solution to the
problems of classification is illusory given the complexity of compound
instruments being examined. While research suggests that instruments have
features more like equity or more like debt under particular definitions, these
lines of research do not support a particular approach to determining an
effective way to define equity and liabilities. We examine several approaches to
the issues currently being considered by the standard setters, which include
improving the definition and enhancing presentation and disclosure. We also
discuss the limitations of extending the component approach to classification
and whether using a mezzanine category in the financial statements would
improve accounting in this area.
The remainder of our study is structured as follows. Section 2 outlines the
principles in the Framework and IAS 32 for distinguishing liabilities and
equity. The definitions in the literature are compared, and differences are
noted. Section 3 provides information about the extent of use of compound
financial instruments and discusses the type of problems experienced in
practice when IAS 32 is applied. Section 4 presents the research that provides
insights into these problems or is informative for standard setters regarding
the effects of classification of debt and equity, and illustrates opportunities for
future research. Section 5 evaluates the possible ways in which the IASB
could advance the project on Financial Instruments with the Characteristics of
Equity and refers to the Board’s discussions in 2016 and 2017. Section 6
concludes.
2. Defining debt and equity
2.1. Guidance from the Framework
The Framework lists the five elements of financial statements: assets,

liabilities, equity, income and expenses. All transactions in accounting are
classified into one of these elements; and the assumption is that the
classification captures the economic characteristics of the transaction (IASB,
2010a, para 4.2). The Framework provides definitions of the elements. An asset
is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity while a liability is a
present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying
economic benefits (IASB, 2010a, paras 4.4(a) and (b)).5 Equity is the residual
interest in the assets of the entity after deducting all of its liabilities (IASB,
5
These definitions are under review as part of IASB’s project to revise the Framework
(IASB, 2016a).

2010a, para 4.4(c)). Therefore, the classification of items as liabilities also

affects what qualifies as equity. However, this current guidance is unlikely to be
sufficient for classification in all cases because of the nature of the classification
problem. When an instrument has attributes of both equity and debt, the
classification is not straightforward, and judgements must be made about the
characteristics on which classification is made.
2.2. Accounting standards guidance and definitions
There are two characteristics of financial instruments that are commonly

considered as a basis for a conceptual distinction between debt and equity. The
first approach, referred to as the liquidity or solvency approach, considers
whether the entity has an obligation to transfer cash or other assets of the
entity.6 The second approach, referred to as the ownership or residual
(valuation) approach, considers whether the returns to the instrument holder
are independent of the entity’s performance. Standard setters have made use of
both these approaches (Botosan et al., 2005). The IASB has confirmed that
financial statements are prepared from an entity perspective (IASB, 2010a, para
OB2) and that financial statements should report economic phenomena that
affect the entity and not those that affect capital providers (a proprietorship
perspective) (IASB, 2014a).
IAS 32 states the requirements for classification and presentation of financial
instruments into financial assets, financial liabilities and equity instruments,
and provides guidance about the classification of interest, dividends and gains
or losses on these instruments.7 As shown in Table 1, IAS 32 defines a financial
liability with reference to a contractual obligation to deliver cash or another
financial asset to another entity or to exchange financial assets or liabilities with
another entity under potentially unfavourable terms. The definition also has
specific requirements in relation to a contract that will be settled in an entity’s
own equity instruments.8
IAS 32 begins with the solvency approach and then adds to the liability
classification by incorporating some elements of the ownership or residual
approach. Thus, there are several instances where application of the
6
In this case, liquidity refers to the ability to meet short-term obligations and solvency
refers to the ability to meet long-term liabilities when they fall due.
7
In addition to IAS 32, the accounting standards that guide accounting for and
disclosure of financial instruments include International Accounting Standard 39
Financial Instruments: Recognition and Measurement (IAS 39) (IASC, 1999), Interna-
tional Financial Reporting Standard 7 Financial Instruments: Disclosures (IFRS 7)
(IASB, 2005), and International Financial Reporting Standard 9 Financial Instruments
(IFRS 9) (IASB, 2010b). See Appendix 1 for further details. See Bradbury (2003) for a
description of the development of accounting standards for financial instruments.
8
Generally referred to as the “fixed-for-fixed” test.

Table 1
IAS 32 definitions
IAS 32 Paragraph 11
A financial liability is any liability that is:
1 a contractual obligation:
a to deliver cash or another financial asset to another entity or

b to exchange financial assets or financial liabilities with another entity under conditions that
are potentially unfavourable to the entity; or
2 a contract that will or may be settled in the entity’s own equity instruments and is:
a a nonderivative for which the entity is or may be obliged to deliver a variable number of the
entity’s own equity instruments, or
b 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 entity’s own equity instruments. For this
purpose, rights, options or warrants to acquire a fixed number of the entity’s own equity
instruments for a fixed amount of any currency are equity instruments if the entity offers the
rights, options or warrants pro rata to all of its existing owners of the same class of its own
nonderivative equity instruments. Also, for these purposes the entity’s own equity
instruments do not include puttable financial instruments that are classified as equity
instruments in accordance with paragraphs 16A and 16B, 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 and are classified as equity instruments in accordance with paragraphs
16C and 16D, or instruments that are contracts for the future receipt or delivery of the
entity’s own equity instruments
An equity instrument is any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
Framework compared to IAS 32 results in different accounting outcomes (see

IASB, 2008, paras 30–32). The definition of equity in IAS 32 is similar to that in
the Framework; it refers to a contract that evidences a residual interest in the
assets of an entity after deducting all of its liabilities. As with the Framework,
the definition of liability would be applied first in the classification hierarchy
(PAAinE, 2008, p. 29).
The IASB’s 2008 Discussion Paper noted that the principle in IAS 32 was
straightforward: if a financial instrument does not meet the definition in IAS 32
of a financial asset or liability, it is classified as an equity instrument. That is,
only financial instruments that evidence a residual interest in the assets of an
entity after deducting all of the entity’s liabilities are classified as equity (IASB,
2008, para 16). In this regard, the principle is similar to the relevant concepts in

the Framework, as discussed above. However, International Accounting

Standards Board (IASB) (2008) stated that problems arose in the application
of this principle, relating to (i) determining whether a contractual obligation
exists; (ii) applying the fixed-for-fixed criterion9 ; and (iii) determining whether
a contingent settlement provision exists (IASB, 2008, para 17).10
IAS 32 has been revised on many occasions, and some of these revisions
concern the debt–equity distinction (See Table 2 for more details). The various
amendments suggest that the underlying principle in IAS 32 (as stated above)
was not being applied in a satisfactory way (or was not adequate), possibly
because the principle alone is not sufficient to deal with the complexity of the
financial instruments and accounting for issuance of an entity’s own shares.11
On June 2016, the IASB work plan included a research project Financial
Instruments with Characteristics of Equity (FICE) (IASB, 2016c) to investigate
the potential improvements. We refer to this work in Section 5. The next
section of our study discusses the use of these instruments in practice and the
issues associated with their use.
3. Extent of use of compound instruments and practical issues
3.1. Extent of use
In Australia, the use of compound financial instruments is small but growing,

and has been a feature of capital structures for several decades (Davis, 1996).
Table 3 shows the increasing capitalisation of the hybrid security segment listed
on the Australian Securities Exchange (ASX).12 The broad categories are
9
See Table 1 – IAS 32 para. 11(b).
10
Following the discussion paper in 2008 (IASB 2008), the IASB worked on the financial
instruments with the characteristics of equity (FICE) project until 2010 when it was
discontinued due to the pressure of other work (IASB, 2014c).
11
A joint attempt by the IASB and Financial Accounting Standards Board (FASB) to
develop a new model in which classification of an instrument was based on whether the
instrument would be settled with assets or with equity instruments of the issuer was
suspended in October 2010. Feedback from external reviewers raised significant
concerns. These including the following: (i) there was a lack of clear principles; (ii)
the model could produce inconsistent results when applied to broadly similar
instruments; and (iii) the ‘specified-for-specified’ criterion was unclear and would be
subject to the same difficulties of interpretation as the ‘fixed-for-fixed’ criterion (EY,
2016, p. 3232).
12
‘Hybrid securities’ is a generic term to describe a security that contains elements of
debt and equity securities, and can therefore include an embedded derivative. We use the
term ‘hybrid’ consistent with the ASX description of this market segment. We also use
‘hybrid’ below where research has used this generic classification. For this article, we use
the terms ‘compound’ and ‘hybrid’ interchangeably.

Table 2
Relevant amendments to IAS 32
Date Amendment
1998 The definition of liability was extended to include an instrument that would be
settled with a variable number of shares
2003 The definition was further extended, and the ‘fixed-for-fixed’ principle was introduced.
Other changes related to settlement options and measuring components of a
compound financial instrument (IAS32: IN12, IN13). In addition, guidance from
interpretation committee decisions was added to the standard (IAS 32: IN 10, IN11)
2008 Relating to puttable financial instruments and obligations arising only on liquidation.
As a result, some financial instruments that would have met the definition of financial
liability will be classified as equity because they represent a residual interest in the net
asset of an entity (IAS 32 16A-D)
Source: IAS 32; Deloitte (2016) http://www.iasplus.com/en/standards/ias/ias32.
convertible or converting debt securities, preference shares and capital notes

that include debt securities with equity-like features.13
The instruments listed on the ASX form only a small subset of the total
hybrid instruments issued by Australian listed companies. Table 4 shows the
number of listed companies in each sector that have issued various types of
hybrid instruments. As can be seen from the table, 1390 companies have issued
some type of hybrid instrument. This is 71 percent of the 1968 companies listed
at the time. The majority of the instruments issued are call options, many of
which are part of the remuneration arrangements within the scope of IFRS 2.
Most of the issuing companies come from the energy, health care, information
technology and material sectors.
In studying the use of hybrid financial instruments, Dutordoir et al. (2014,
p. 3) noted that US corporations raised a total of US$510 billion through
convertible debt issues over the period 2000 to 2011. This compares with US
$1146 billion raised through seasoned equity issues, and US$6635 billion
raised through straight bond issues. Western European firms raised US
$189 billion in convertible bonds over the period 2000–2011, and Japanese
firms were reported to have raised US$112 billion in convertible bonds over
the same period.14 Dutordoir et al. (2014) also observed an increase in
convertible bonds issued in the United States to qualified institutional
investors on secondary markets, rather than issued through public markets,
with evidence that these convertible bonds catered to the hedging needs of
arbitrageurs such as hedge funds.
13
The rationale for, and the capital market effects of, the issuance of hybrid securities in
Australia are documented in Suchard and Singh (2006) and Suchard (2007).
14
These measures are based on samples of security offerings retrieved from Thomson
One Banker’s New Issues database.

Table 3
Market capitalisation of hybrids listed on the ASX
ASX total
Preference Convertible market
shares, bonds (AUD Total hybrids capitalisation
As at July capital notes† (AUD billion) billion) (AUD billion) (AUD billion)
2016 33.4 1.1 34.5 1728

2015 28.8 1.2 30.0 1686
2014 26.6 1.9 28.5 1627
2013 21.6 1.9 23.5 1421
2012 16.8 1.3 18.1 1229
2011 15.5 1.3 16.8 1307
2010 15.7 1.2 16.9 1309
2009 12.7 2.1 14.8 1193
2008 18.0 2.8 20.8 1291
†
Includes convertible preference shares.
Source: Australian Securities Exchange (ASX) Hybrids Monthly Update.
3.2. Issues in practice
Examples of classification issues in practice are shown in Table 5. Securities

with characteristics of debt and equity can be designed with a wide range of
complex features. For example, coupons can be linked to variable or fixed
interest rate benchmarks, company earnings, earnings of a subset of company
assets or commodity prices. Principal repayments can be due over varying
periods, typically from 12 months to 10 years, or never (for perpetual
instruments). Conversion can be on a specific date, linked to an event (such
as an initial public offering or asset beginning production), or dependent on a
share price or index threshold. Conversion can be automatic or at the issuer’s
or lender’s option. The number of shares issued on conversion can be fixed or
may vary in response to changes in the share price. The conversion can also be
subject to antidilution adjustments that compensate for share splits, large
dividends, capital reductions or significant new share issues.15
Features of compound or hybrid instruments can be selected so as to create
instruments that cover each point in the spectrum, from a simple debt
instrument with fixed interest and principal repayments to an instrument that is
effectively a traditional ordinary share. Each feature needs to be analysed under
IAS 32 to determine whether it is a separate component, whether that
component is a liability, equity or derivative in nature, or whether the feature
affects the classification of another component. Problems in practice may relate
15
An example of empirical research on conversions in the Asia-Pacific region is Greiner
et al. (2002).

Table 4
Hybrid instruments issued by companies listed on the ASX
Convertible
note Call Floating Preference Number of
Industry sector or bonds options rate note securities Rights companies
Consumer 9 55 4 1 52 96
discretionary
Consumer staples 4 20 1 3 15 31
Energy 20 165 1 4 61 183
Financials 20 75 8 11 28 108
Health care 12 124 1 1 37 127
Industrials 7 70 – 6 45 104
Information 13 127 – 48 144
technology
Materials 40 495 – 4 137 534
Real estate 5 16 – 3 19 32
Telecommunication 1 13 2 1 7 18
Services
Utilities 3 10 1 1 13
Total 134 1,170 18 34 450 1,390
The table indicates the number of companies that have hybrid instruments listed in the Issued
Capital section of the Morningstar DatAnalysis database on 18 August 2016. Securities
issued under the following codes were included in the count: BND, CNV, COP, FRN, MTN,
NIS, PRF, RGT, RGTS, UNS, WGT and WNT. All codes that could be considered hybrid
instruments have been included. Within FRNs, for example, are subordinated, perpetual and
exchangeable notes. The last column shows the number of companies in each sector that have
issued hybrids (as some companies have issued more than one type of instrument, this column
is not a simple sum of the other columns).
to identifying or valuing the components or determining the treatment of an

unusual redemption premium. See the example in Table 5 on short-term
convertible notes.
As explained in Section 2, there is a principle for debt–equity classification in
IAS 32. However, EY (2016, p. 3236) states that the application of the principle
is ‘often far from straight forward’. The classification involves two steps: first,
the entity must first consider whether the individual instrument or class of
instruments issued by the entity is a financial liability or equity; and second,
whether the entity settles an obligation using instruments issued by itself that,
when considered in isolation, could be classified as equity, IAS 32 requires the
entity to consider if the instrument is a financial liability (IAS 32,para 16). The
classification is made on initial recognition and in general is not subsequently
changed.
The application of the definitions in IAS 32 (see Table 1) means that an
instrument is an equity instrument only when it does not include a contractual
obligation to deliver cash or another financial asset; or to exchange a financial

liability or financial asset with another entity under conditions that are
potentially unfavourable to the issuer. Thus, an instrument is equity under IAS
32 if the issuer has an unconditional right to avoid delivering cash or another
financial instrument, it is a nonderivative that is settled by delivering a fixed
amount of the entity’s own equity instruments, or it is a derivative that requires
an exchange of a fixed amount of cash for a fixed number of the entity’s own
equity instruments. In all other cases, it would be classified as a financial
liability.16
Thus, the critical feature in differentiating a financial liability from an equity
instrument is the contractual obligation of the issuer of the financial instrument
to deliver cash or another financial instrument to the holder. IAS 32 focuses on
contractual rights and obligations and not on probabilities of outflows of cash
and other resources associated with those rights.17 The example of contingently
convertible bonds in Table 5 illustrates the classification hinging on seemingly
minor terms with no consideration of the likelihood.
IAS 32 requires the financial instrument to be classified based on substance
over form (IAS 32, para 15). While they may be commonly the same, there are
cases where items are equity in legal form but liabilities in substance (e.g. some
preference shares and units in open-ended funds or unit trusts such as units
issued by a limited life trust as shown in Table 5). The opposite can also occur –
instruments which are in practical terms perpetual debt must be classified as
equity instruments. Also, ‘substance’ is often determined by considering the
legal rights of the holder of the financial instrument, thus pointing to the
importance of legal conditions in dictating classification.18 See the example in
Table 5 on long-dated redeemable preference shares.
16
We note that the approach of IAS 32 differs to that in International Financial
Reporting Standard 2 Share-based Payment (IFRS 2) (IASB, 2004). IFRS 2 treats any
transaction within its scope that can be settled only in shares or other equity instrument
as an equity instrument (which is consistent with the Framework). Unlike in IAS 32,
whether the number of shares to be delivered is fixed or variable is not a decision factor
in IFRS 2. The inconsistency in approach between the two standards is a matter to be
addressed in future work of the IASB. See Appendix 2 for a summary of the current
rules in IAS 32 and IFRS 2.
17
To recognise a provision under International Accounting Standard 37 Provisions,
Contingent Liabilities and Contingent Assets (IAS 37) (IASC, 1998), the probability of an
outflow is considered. This is based on the definition of a liability and recognition
criteria of the Framework. Prior versions of IAS 32 contained a probability hurdle in
relation to the liabilities, which was removed in the 2003 revisions.
18
It is instructive to keep in mind that covenants in debt agreements often reclassify
some of these financial instruments into debt or equity from the perspective of the lender
regardless of their classification in financial statements. Examples from Australia include
Stokes and Leong (1988), Cotter (1998), Ramsay and Sidhu (1998) and Mather and
Peirson (2006).

To extend the examples provided in Table 5, Appendix 3 shows a range of

compound instruments actually issued by the Australian companies. Call
options and performance rights related to executive compensation are the most
common transactions. The details of equity-based compensation for key
management personnel and the balances of option holdings are disclosed in the
remuneration report. Note disclosure of total shares under options outstanding
would also be expected. Less common are a range of restructuring or other
equity raising transactions that include share-based transactions. These
transactions can include combinations of convertible instruments and deriva-
tives. The Appendix also summarises and comments on the accounting used for
the instruments.
Appendix 3 shows that in many instances when transactions do not
involve a direct cash exchange, it is necessary to value the instruments or
parts of the instruments issued to complete the required accounting
treatment. These valuations are often based on inputs that cannot be
observed in external markets or other transactions that the entity has
entered into with outside parties. This can result in a wide range of values,
including in some cases the companies simply valuing the instruments at
nil. It is therefore difficult to determine the value transferred from one
group of equity interests to another as a result of the transaction. A
number of parties, considering the same transaction, are unlikely to arrive
at the same valuation for the transaction. The lack of information is
further exacerbated because these instruments are often not revalued
postissue, and limited disclosure is provided regarding their potential
dilutive effects.
4. Insights from research
In this section, we discuss studies on compound financial instruments.19

First, we explore studies relevant to the understanding the effect of
accounting rules on what instruments are issued and how those instruments
are structured. Next, we examine the impact of accounting for compound
instruments for users. A list of papers is provided in Appendix 4. Not all
papers in the appendix are discussed below; however, the appendix provides
an overview of the research in the area to assist in the development of future
research.
19
Relevant papers were identified by searching the Internet via Google Scholar using the
key words ‘liability versus equity’, ‘hybrid financial instruments’, ‘compound financial
instruments’, ‘preference shares’, ‘preference capital’, ‘convertible debt’, ‘convertible
notes’ and then working through linked references and citations. In addition, we
searched the websites of several top regional accounting journals using the same search
terms.

Table 5
Examples of compound financial instruments
Compound instrument Key terms/features Classification under IAS 32 Comments
Short-term convertible • Duration – 12 to 24 months Liability with embedded equity The split accounting required by
notes • Converts into fixed number of shares, component IAS 32 results in complex
but subject to antidilution clauses High volatility in underlying shares accounting for this instrument.
• No coupon can lead to significant value For small entities, it can be
• Large redemption premium – 20 to allocated to the equity component difficult to value the two
50% of issue value The large redemption premium can components. If the notes convert
result in a high effective interest into shares based on the share
rate charge in the income price at the time of conversion (a
statement variable number of shares) the
entire instrument would be
classified as debt. Some
practitioners suggest that the
redemption premium should be
accrued almost immediately,
resulting in a significant expense
around the time of issue of the
instrument
Contingently • Duration – 5 to 10 years Instrument classified as a liability if Classification of the instrument can
N. Fargher et al./Accounting & Finance
convertible bonds • Pays dividend based on fixed interest it converts into a variable number hinge on seemingly minor terms.
rate or based on typical interest rate of shares, or equity if a fixed Generally, there is no
benchmark number of shares consideration of the likelihood of
• Dividend not cumulative, but if divi- the trigger event occurring, thus
dend unpaid no dividends can be paid this clause can have a significant

to ordinary shareholders impact on the classification even
though the probability of the
event occurring could be quite
13
(continued)
Table 5 (continued)
14
• Converts into ordinary shares on small. In this case, this clause

maturity either at fixed rate or based on alone could result in an
the share price at maturity instrument that would otherwise
• Converts immediately on occurrence of be classified as equity being
a trigger event, normally linked to classified as a liability
capital levels or regulator intervention These types of instrument are
common in the banking industry
where they often qualify as equity
for regulatory capital purposes
Units issued by limited • Duration – 80 years The limited life of the trust and the This instrument is equity from a
life trust • Trust must distribute taxable income requirement to distribute certain valuation perspective and would
every year profits would result in liability normally rank last in a
• Assets distributed to unit holders when classification liquidation. The returns on the
the trust is wound up at the end of The instrument may qualify for the instrument and rights to assets on
80 year life IAS 32.16E exemption that would liquidation are solely dependent
allow for equity presentation in on the entity’s performance. The
the entity’s balance sheet equity-like nature is supported by
the fact that the paragraph 16E
exemption exists. The exemption,
however, does not apply to the
presentation of noncontrolling
interests or to the treatment of
investments in these types of
instruments under the financial
asset rules in IFRS 9

The same considerations would
apply to a puttable instrument
with similar features, except that
(continued)
Table 5 (continued)
the paragraph 16E exemption

would not be available due to the
requirement to distribute taxable
income (IAS 32.16A(d))
Long-dated redeemable • Duration – 10 to 20 years Compound instrument with This instrument is debt from a
preference shares • Pays dividend based on fixed interest liability and equity component valuation perspective and would
rate or based on typical interest rate Liability component based on normally rank prior to ordinary
benchmark present value of the amount shares in a liquidation. The
• Dividend subject to normal statutory payable on redemption (thus most dividends are also specified with
restrictions and directors’ discretion of the instrument’s initial value reference to external benchmarks
• Dividend not cumulative, but if divi- will be allocated to equity) typically used by debt
dend unpaid no dividends can be paid Various features designed to instruments. These types of
compel payment of dividend to instruments may also qualify as
to ordinary shareholders
preference shareholders, but debt for tax purposes
• Unpaid dividends may also trigger
economic compulsion not The various mechanisms used to
other rights, for example board of
considered in classification of induce payment of the dividends
directors’ representation or loaded
instrument may mean that the company has
voting rights in shareholder meetings no real alternative to paying
dividends on the instrument
This table lists four examples of compound instruments found in Australia. The examples have been chosen to illustrate the application of IAS
32 in certain cases and potential problems with the current standard.

15
4.1. Effect of accounting standards on what instruments are issued and how those
instruments are structured
There is an extensive literature on how companies select financing

instruments. This literature suggests that classification required by accounting
standards influences firms’ behaviour. Companies seek compound financial
instruments with classifications that suit their objectives regarding preferred
capital structure.20
Dutordoir et al. (2014) identified four motivations for issuing convertible
bonds in the United States: backdoor-equity financing; risk shifting to reduce
agency costs (shareholders share in cash flows from high-risk strategies with
convertible bondholders); allaying uncertainty where there is an assumption of
information asymmetry between managers and outside investors and the
conversion option is valued to result in a fairly priced security; and sequential
financing if the firm is unable to issue equity. Lewis and Verwijmeren (2011)
pointed to similar motivations and Suchard and Singh (2006) and Suchard
(2007) provided consistent Australian evidence regarding incentives to issue
convertible bonds.
Research from the United States has shown the design of compound
instruments to selectively classify the instruments as equity, to reduce the
reported debt for financial reporting purposes or to gain tax benefits from the
deduction of coupon payments (e.g. King and Ortegren, 1988; Engel et al.,
1999; Levi and Segal, 2015). Scott et al. (2011) presented evidence about the
classification of convertible debt based on a component approach for Canadian
firms in the period 1996–2003. The authors concluded that the classification
discretion available allowed firms to structure their convertible debt to achieve
debt minimisation on the balance sheet. There is also evidence suggesting US
managers will structure convertible securities to gain favourable effects on
diluted earnings per share (Marquardt and Wiedman, 2007b; Lewis and
Verwijmeren, 2014).
Studies also suggest that tax implications are a major factor in firms’
decisions to issue compound securities. For example, Seminogovas (2015)
argued that differences in taxation and accounting between European Union
(EU) member states created distortions in the treatment of compound financial
instruments within cross-border groups and led to the amendment of the EU
20
Two quotes illustrate motivations behind companies’ choices regarding financing
structure. EY (2016) describes the ‘holy grail’ of financial instrument accounting as
devising ‘an instrument regarded as a liability by the tax authorities (such that costs of
servicing it are tax deductible) but treated as equity for accounting and/or regulatory
purposes (so that the instrument is not considered as a component of net borrowing)’.
World Accounting Report (1991, p. 11) states: ‘The dream of every finance executive is a
hybrid instrument, which is classified as equity when calculating gearing ratios, but does
not dilute ordinary shares and share price, is as cheap as debt, and whose return ranks as
interest for tax purposes.’

parent-subsidiary directive in 2014. Differences in tax law internationally

introduce the possibility that the same financial instrument can be categorised
as debt in one jurisdiction and equity in another, which may provide tax
planning opportunities for multinational firms (Johannesen, 2014). The links
between tax treatment and financial reporting are usually not relevant to
standard setters. However, to the extent that management seeks to lower
effective tax rates through the issue of compound securities that increase the use
of debt in the financing mix, financial statements must adequately disclose the
increased risk.
One conclusion based on the research cited above is that, given the incentives
to strategically use compound securities to achieve particular classification
outcomes, there is a need for a classification system that gives a fair
representation of the underlying economic substance of instruments and
reduces the risk of transaction structuring intended to influence the perceptions
of risk or performance.
4.2 The effect of classification on the decision-making of users
Classification is important because it has the potential to affect the decision-

making of users of financial statement information. However, there is only
limited evidence about the impact of classification. Hopkins (1996) investigated
whether the balance sheet classification of financial instruments that include
attributes of both debt and equity (i.e. mandatorily redeemable preferred stock)
affected the share price judgements of US buy-side financial analysts. Hopkins
(1996) found that analysts presented with an instrument classified as a liability
predicted share prices that were higher than prices predicted by analysts
presented with the instrument classified as equity and that the difference was
linked to analysts’ understanding of debt and equity valuation effects. Further,
the author showed that analysts’ judgements made more use of a category-
based process when the instrument was classified as debt or equity and more
use of an attribute-based decision process when the instrument was classified as
mezzanine.
da Costa Jr et al. (2016) replicated the method of Hopkins (1996) using
Brazilian analysts to evaluate the effect of balance sheet classification of a
compound financial instrument on analysts’ judgements. The authors found
that regardless of the balance sheet classification, the analysts generally
defaulted to viewing the instrument as a liability.
There is a general lack of research about how analysts adjust forecasts of
balance sheets, profit or loss and cash flows for compound securities.21 Clor-
21
A New Zealand study showed that the application of the IFRS equivalent standard
(NZ IAS 32) to the reporting of convertible financial instruments resulted in higher
amounts of liabilities and interest. Thus, analysts would need to adjust their benchmarks
when assessing risk and performance of companies (Bishop et al., 2005).

Proell et al. (2016) used an experiment to test how experienced US finance

professionals incorporated disclosed features of compound financial instru-
ments in credit-related judgements. The authors concluded that the accounting
classification does not significantly influence these users; their judgements are
largely dependent on the underlying features of the instrument. That is, the
study showed that disclosing the features of the instrument is a key issue, of
more importance than how the items are classified.
Clor-Proell et al. (2016) also examined the use of information on priority in
liquidation, voting rights, settlement in cash versus shares and dependence on
profitability for payments to holders. They found that experienced users vary in
their beliefs about which individual features are most important in distin-
guishing between liabilities and equity, pointing to the importance of
disclosure. This type of research can highlight the relevance of specific
disclosures, but it does not address the practicality of mandating the disclosure
of sufficient information for all instruments and all entities.
Turning now from the effect of classification on individual analysts and
considering the market as a whole, a few studies have investigated the
relationship between compound securities and systematic risk. In the United
States, Kimmel and Warfield (1995) reported that the market perception of a
hybrid security was conditioned on attributes such as voting rights and
conversion features. The authors concluded a dichotomous classification may
not provide sufficient information about these securities. Similarly, Cheng et al.
(2003) concluded that a dichotomous classification was insufficient to provide
representational faithfulness regarding reporting of hybrid securities (in their
study, redeemable preference securities). Terando et al. (2007) studied cash and
share-put warrants in the United States. They found market participants
differentially valued the two types of warrants, based on solvency character-
istics. The authors concluded the instruments should be reported separately on
the balance sheet.
An Australian study explored the effects of changes in classification and
disclosure about hybrid financial instruments on systematic risk. Using data
from the pre-IAS 32 period, Godfrey et al. (2010) investigated the introduction
of AASB 1033, which required the classification of hybrid securities according
to their economic substance rather than their legal form. The authors reported
that firms’ systematic risk was significantly lower after they adopted the new
classification. The authors concluded that the new accounting classification
rules provided more transparent information to investors and reduced
information asymmetry, but only after investors had observed the impact of
the change on firms’ financial statements.
Further evidence of the importance of disclosure is provided in a study
investigating the effects of changes in reporting requirements. Marquardt and
Wiedman (2007a) reported inconsistent and inadequate disclosure of contin-
gent convertible securities by US firms under SFAS 129 prior to 2004.
Following new guidance where the FASB required disclosure of the conversion

features and their potential impact on EPS (FASB, 2004), the authors reported
higher levels of specific disclosures, but only 42 percent of the sample reached
the highest level of disclosure according to the researchers’ disclosure scale.
These studies suggest that disclosure of relevant information is paramount.
Further, Peasnell (2013) proposed that if financial statement users are well
informed, then whether a claim is classified as a liability or equity is of little
consequence. If users can recast the items on a balance sheet to the desired
category at relatively low cost, then disclosure, not classification, is the more
important issue. The key point is whether there is currently sufficient disclosure
for users to adjust the classifications adopted by firms to arrive at a different
classification.
Disclosure can improve the transparency and understandability of balance
sheet amounts. It can also provide information to assist users when potentially
relevant transactions or other events have not been recognised in the financial
statements.22 In other cases, disclosure can permit users to adjust the financial
statements to determine the effects of an alternative accounting classification.23
The more recent standards relating to financial instruments (e.g. IFRS 7 and
IFRS 9) have extensive disclosure requirements. The extent to which investors
find these disclosures helpful is the subject of discussion and debate (see, e.g.,
Bean and Irvine, 2015). However, it is unlikely that these disclosures provide
sufficient information for financial statement users to attempt to reclassify a
debt instrument as equity.24 The complexity of the features of the underlying
instruments and the nature of the disclosures usually provided are unlikely to
provide sufficient information to permit a reclassification by an investor or
analyst.
4.3. Future research
We have discussed research that is relevant to the understanding the effects of

the debt–equity classification in accounting standards. A limitation of these
studies is that the evidence comes mainly from US firms and from periods of
time when specific accounting standards allowed the examination of apparent
structuring behaviour to be observed. Thus, the evidence may not be
generalisable to other periods or to IFRS adopting firms. The evidence shows
22
For example, some intangible assets and contingent liabilities are disclosed but not
recognised.
23
For example, National Australia Bank’s (NAB) non-GAAP cash earnings report
shows distributions on instruments classified as equity per IAS 32 as interest, thus
signalling to investors the instrument should be treated as debt (NAB, 2016).
24
Financial analysts use models for the valuation of many types of compound securities.
The input parameters to such models would necessarily rely on the disclosure of the
contractual obligations for each particular instrument and may therefore require an
excessive amount of disclosure.

the effect of classification into the elements (liabilities, equity) on financing

choices. However, it does not show how firms apply the classification principle
and the extent to which applying the principle is a problem for them.
Botosan et al. (2005, p. 170) identified several areas where research could
contribute and their calls for research are still timely. The authors stated that
research providing evidence relevant to determining classification principles
and disclosure requirements that meet a variety of users’ needs would be useful,
including evidence about the attributes of instruments that are used to
distinguish debt and equity. They also called for more research about how
classification affects users’ assessments of firms’ performance, risk and value.
While there has been some subsequent research around these questions, they
remain largely unaddressed and there continues to be a dearth of research in
jurisdictions applying IFRS.
A potential issue of concern for researchers is the effect of the debt–equity
classification on the financial statement data used in academic research. Most
studies in accounting and finance use data from large-scale databases provided by
commercial providers who in turn draw the data from companies’ published
financial statements and other media releases. The assumption of researchers is that
the classifications of debt and equity can be relied upon in their various analyses. If
researchers assume the classification captures the economic characteristics of
elements (consistent with the assumption of the Framework) but classification does
not do this, then inferences drawn from research may not be sound. The issue of
accounting for compound securities may be of most concern in studies involving
measurement of leverage, distance to default or other aspects of risk.
5. Responses to the classification problem
In this section, we outline four ways the standard setters could respond to the
issues discussed above. They include the following: improving the definition of
liability; revisiting the component approach; enhancing presentation and
disclosure; and using a mezzanine category. The approaches are not mutually
exclusive. We also discuss current IASB activity and how it relates to the four
proposals.
5.1. Improve the definition of a liability
As discussed in Section 2, the distinction between a liability and equity under

IAS 32 is based on underlying principles, but rules have been added over time
to assist preparers when applying the standard. As more rules are added to a
standard through modifications and interpretations, the ability to work around
the rules to arrive at desired classification choices and financial reporting
outcomes increases.25
25
See Schipper (2003) for a discussion of principles and rules in accounting standards.

Schmidt (2013) argued that standard setters appear reluctant to reconsider

the use of a dichotomous classification based upon the existence of a
contractual obligation. Standard setters have adjusted the dividing line
between liabilities and equity, for example, by adding or removing exceptions
but they have not reached agreement on approaches that challenge the basic
debt–equity classification at a conceptual level.
Thus far, the standard setters’ experience of IAS 32 suggests that additional
rules and guidance to make the liability–equity distinction clearer are unlikely
to achieve consistency and comparability in the classification of compound
instruments. Standard setters are unlikely to be able to arrive at definitions for
assets, liabilities and equity that are broad enough to accommodate commercial
variation yet tight enough to avoid transaction structuring. In addition, the
nature and variety of compound instruments on offer will continue to evolve,
such that new instruments will be produced in response to any changes in rules
regarding the classification of compound instruments. It is not clear to us that
modifying definitions of assets, liabilities and equity will be sufficient to address
the problems relating to the classification of compound instruments.26
5.2. Improving the separation of component approach
In its present form, IAS 32 requires the separation of compound financial

instruments into their various constituent elements; liabilities, assets and equity
instruments (IAS 32, para 28).27 The component approach may solve some of
the problems identified in our study, because an instrument with mixed
characteristics can be split into separate components that can be more readily
identified as liabilities, assets and equity. However, the component approach is
predicated on a robust definition of the possible components and will not
provide a solution if such definitions are not available or are easily
circumvented.28
Another problem is actually identifying and measuring the various compo-
nents. In many cases, there will be more than one way of dividing the
instrument into different parts and it may be difficult to prescribe rules that
dictate the division process so that all preparers end up with the same
26
Note the difficulties faced in defining the relatively more straightforward convertible
debenture in the 1970s (Clancy, 1978).
27
The IASB’s in-progress FICE project indicates that the IASB intends to retain the
components approach. See, for example, IASB (2017).
28
See Casson (1998) for more detailed discussion of problems of identification and
measurement.

components.29 The components will need to be measured for valuation

purposes, involving models and assumptions and possibly leading to estimates
which may be noncomparable and unreliable.
Under the present standard, the components are determined at the time of
issue, and not revisited thereafter (IAS 32, para 30). As the different
components will be subject to different accounting rules, only some of these
components maybe revalued postinitial recognition. For example, derivatives
are remeasured to fair value, but most liabilities are carried at amortised cost
(using the effective interest rate method). Equity components are not
remeasured at all. Thus, the carrying value of some of the components will
diverge from the underlying fair value over time. This relieves preparers from
the task of repeating the complex valuation exercise for some components
postissue, but any weaknesses in the original division will be carried forward
for the life of the instrument and may be magnified over time.
In summary, we conclude that the solution does not lie solely in improving
the component approach. The problems already discussed with the definitions
of liability and equity are embedded in this approach. Practice shows the
component approach has problems with regard to identifying and valuing the
components, and these problems are not likely to be addressed by improve-
ments to the rules and guidance in the existing standard.
5.3. Improve accounting through enhancing disclosure
Research points to the important role of disclosure; thus, we expect that

changes to disclosure requirements could assist the users of financial informa-
tion. Prior commentary points out that the dichotomous debt–equity classi-
fication provides information by focusing on only one characteristic related to
the nature of the claim (e.g. solvency risk). However, the inherent complexity of
compound instruments cannot be addressed by a singular relevant character-
istic such as ownership or subordination (Hopkins et al., 2009). Kimmel and
Warfield (1993, 1995), Terando et al. (2007) and Schmidt (2013) have
concluded that a dichotomous classification approach cannot reflect the
economic substance of compound instruments because the focus on a
particular valuation characteristic is unlikely to meet the information needs
of users in all cases.
Presently, the process of valuing ordinary equity benefits the least from
existing disclosure requirements. IFRS 7 requires disclosure of an entity’s
exposure to risk arising from financial instruments (IFRS 7, para 1).The
disclosure is to be based on information provided internally to key manage-
ment personnel (IFRS 7, paras 34). These disclosures are generally given at an
29
In January and May 2014, the IFRS Interpretations Committee discussed a
compound instrument that could be divided in four different ways under the existing
IAS 32 guidance (IASB, 2014d).

aggregate level reflecting the exposures and risks of all financial instruments.
Under IFRS 7, no disclosure is required for instruments classified as equity.
Consequently, a user would, for example, be challenged to accurately assess
any shifts in value between the value accruing to compound instrument holders
and the residual value to existing ordinary shareholders under the existing
disclosure requirements. This omission emphasises the need for improvements
in disclosure in this area.30
While these additional disclosures may improve the current position, research
highlights the difficulty of developing general guidelines that will result in
adequate disclosure (Marquardt and Wiedman, 2007a). Further, research on
the valuation of compound instruments (as discussed in Section 4) suggests
that the disclosure of a large number of parameters would be needed to
adequately illustrate the valuation models presently used in financial analysis.
For example, financial statement users need disclosures about the nature of
claims including the voting rights associated with the claim, the claim’s
maturity date or perpetual nature, performance-related or fixed payments
required to service the claim, conditions of settlement, means for settlement in
cash or equity, obligations for forfeiture and the level of subordination, among
other things (see Schmidt, 2013). Entities with multiple compound instruments,
in particular, may find it difficult to provide all the necessary information.
5.4. The mezzanine approach
Some prior accounting practice has presented compound instruments in a

mezzanine category. For example, SEC registrants have used a mezzanine
category (or temporary equity) since the release of Accounting Series Release
No. 268, Presentation in Financial Statements of ‘Redeemable Preferred Stocks’
(ASR 268) (SEC, 1979) in 1979.31 In the United Kingdom, prior to the
adoption of IFRS, shareholders’ funds were split into equity and nonequity
30
Part of the solution may lie in the calculation of diluted EPS. A significant review of
the existing International Accounting Standard 33 Earnings per Share (IAS 33) (IASC,
1997) is long overdue. Many of the methods in the existing standard were formulated in
the 1960s and do not reflect the significant advances in accounting and finance since
then.
31
ASR 268 requires preferred securities that are redeemable for cash or other assets to
be classified outside permanent equity if they are redeemable (i) at a fixed or
determinable price on a fixed or determinable date, (ii) at the option of the holder or (iii)
upon the occurrence of an event that is not solely within the control of the issuer. With
the introduction of Statement of Financial Accounting Standards No. 150 Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and Equity
(SFAS 150) (FASB, 2003) in 2003, some of these instruments were reclassified as
liabilities, but ASR 268 is still applicable to securities not affected by SFAS 150
(primarily puttable or contingently redeemable equity securities). These rules are now
codified as ASC 480-10-S99.

interests under Financial Reporting Standard 4 – Capital Instruments (ASB,

1993).32
Research described in the previous section (Hopkins, 1996) provides some
support for the use of a mezzanine category because the mezzanine enhances
the information available to decision-makers, by making more salient the
presence of compound instruments. The need for additional information about
compound securities was highlighted by Wahlen et al. (1999, p. 307) who stated
‘no single decision criterion can completely capture all purposes for distin-
guishing liabilities and equity. . . we believe that financial statement users will be
best served by an orderly sequence of sufficient disaggregation of balance sheet
and income statement elements’.
The mezzanine category could be supported by disclosures to help users
understand the impact of the instruments on solvency risk and potential
dilution of, or constraints on, ordinary shareholders’ returns. A further
suggestion in Ryan et al. (2001) is that the mezzanine be split into those claims
that are:
1 Liabilities from a solvency perspective, and equity from a valuation

perspective (such as obligations to transfer the cash equal to the fair value
of a fixed number of shares); and
2 Equity from a solvency perspective and liabilities from a valuation
perspective (such as an obligation to transfer a variable number of shares
equal to a fixed dollar amount).33
One of the key benefits of the mezzanine category is that instruments with
characteristics of both equity and debt would simply be included in the
mezzanine category, with no need to split into components. The approach to
measuring instruments in the mezzanine (fair value or amortised cost) would
need to be determined.34 Using the mezzanine could thus reduce the complexity
of accounting for compound instruments. It would also help align the
requirements of IFRS with US GAAP, because under US GAAP, compound
32
Nonequity interests were shares that had cash flows that were not linked to the
company’s assets or profits or were redeemable at the option of the holder. Thus, these
nonequity interests were shares with some characteristics of debt.
33
We refer to the solvency and valuation perspectives in general in Section 2.2. The
problem with the Ryan et al. (2001) approach is that it adds another dimension to the
contractual specificity or bankruptcy order approaches mentioned earlier, and it is not
obvious which dimension is better. Thus, it may be preferable for preparers to determine
the approach used and order of the instruments, with sufficient disclosure provided to
assist users to assess the contractual specificity, bankruptcy priority, solvency risk and
ordinary equity valuation effects.
34
If fair value was used, some instruments may need to be componentised in order to
calculate fair value.

instruments are generally accounted for as debt or equity in their entirety, and
not split into separate debt and equity components.35 ,36 Additional disclosures,
particularly around solvency risk and the current value of ordinary sharehold-
ers’ equity, could substitute for the information currently provided by split
accounting.
The treatment of income and expenses related to the items in the mezzanine
would need to be determined, building on the existing approaches in IAS 39/
IFRS 9. There is effectively a mezzanine category in the profit or loss statement
already, that is other comprehensive income (OCI). The OCI section presently
includes items that can be broadly considered part of profit or loss for the
period, but their inclusion in profit or loss could undermine the relevance of
that figure.37,38 Because the yields or restatement of mezzanine instruments
may compromise the relevance of profit or loss, OCI could be used to record
these amounts.39
Schmidt (2013) suggested an approach for the income statement that would
provide additional information. Earnings before interest and tax could be
emphasised as a subtotal, followed by the yields on the various compound
instruments in a specific order. The order would be based, as in the balance
sheet, on the contractual specificity of the instruments yield; that is, first
instruments with a yield linked to a benchmark independent of the business
(interest), and then instruments with yields linked in varying degrees to the
performance of the business and finally instruments with a yield solely linked to
the performance of the business and payable at the discretion of the entity
(dividends).
The use of the mezzanine approach is, however, not without attendant
difficulties. The category still requires robust definitions of liabilities and equity,
to ensure the ‘dividing line’ between liability and mezzanine (and equity and
mezzanine) results in meaningful differences between the instruments in each
category. The application of the definitions could still be debatable and subject
to judgement (as in the present environment) as companies seek to obtain
particular classifications. Further, the mezzanine category could be broad and
thus contain a large, heterogeneous class of instruments with a mix of features
35
With the exception of certain convertible debt instruments that may be cash settled
and bifurcated derivatives.
36
See, for example, comments on p. 10-2 of PwC (2015).
37
Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting (Frame-
work ED) (IASB, 2015, para 7.24).
38
See Detzen (2016), Black (2016) and Bradbury (2016) for reviews of the development
of the OCI section of the profit or loss statement.
39
This approach may not be consistent with the IASB’s current thinking on OCI (see
Framework ED, para7.23–24) and may require a reconsideration of the role of OCI as
well.

between the extremes of liabilities and equity. However, categorisation in the

mezzanine would alert users to the need for more careful assessment of the
accompanying disclosures on aspects of voting rights, income distribution
versus fixed payments, seniority/ranking and so forth.
The mezzanine category would require that items in the profit or loss
statement that represent interest expense or distributions to owners are
presented in a suitable way. In addition, using a mezzanine category does not
alleviate difficulties associated with valuing and remeasuring financial instru-
ments. Some items in the mezzanine that were previously in equity would be
required to be remeasured; however, it is unlikely there will be an active market
for such instruments leading to difficulties in measurement.
Considering current accounting standards, the use of a mezzanine would
raise some specific issues. IFRS 9 requires bifurcation of some instruments, a
treatment that was arrived at after considerable evaluation of theoretical and
practical issues, particularly in relation to the accounting for changes in ‘own
credit’ risk. From a practical perspective, it may be difficult to justify a change
away from a recently promulgated requirement.40 IAS 32 is fundamentally
linked to IAS 39/IFRS 9 so any changes to IAS 32 requirements (such as the
use of a new financial statement element) must be considered in the light of
their impact on IFRS 9.41
5.5. Current approaches in standard setting
The present approach of the Board in the FICE research project is based on
three objectives. They are to: (i) reinforce the underlying rationale of the
distinction between liabilities and equity in IAS 32; (ii) provide better
information through presentation and disclosure; and (iii) improve consistency,
completeness and clarity of the requirements (IASB, 2016b, para 1). In relation
to the first objective, the Board has been developing the underlying rationale of
the liabilities and equity distinction by considering new approaches. The Board
currently favours the Gamma approach,42 which is based on the substantive
rights and obligations established by the contract. This approach is similar to
that of IAS 32 and provides many outcomes similar to that standard (see IASB,
2016b, Appendix B).
40
The Board retained bifurcation of liabilities in IFRS 9 following feedback that
bifurcation was preferable to using fair value measurement and separating out changes
relating to ‘own credit’ and including them in OCI.
41
Classification under IAS 32 gives rise to equity and liabilities; the latter are measured
according to IAS 39/IFRS 9.
42
The IASB has been developing three approaches based on their understanding of user
needs. The Gamma approach attempts to cater for the broadest range of user needs
identified and is essentially an amalgamation of the alpha and beta approaches. See
International Accounting Standards Board (IASB) (2016b, Appendix A).

Regarding the second objective, the Board is proposing to improve

presentation by providing information about: subclasses of liabilities and the
income and expenses that arise from liabilities that depend on residual
amount43 ; and subclasses of equity, in particular attribution of income and
expenses to classes of equity other than ordinary shares. In relation to
disclosure, the Board proposes to improve disclosure requirements to provide
information that is not provided through classification and presentation; and to
improve consistency, completeness and clarity of disclosures for derivatives on
own equity (IASB, 2016b).
The proposed changes, to be presented in a Discussion Paper expected in
2017, will address some of the problems identified earlier in this section of our
study. The Board recognises that difficulties arise from using a binary
distinction for liabilities and equity, and applying it to a wide range of claims
with various features. In addition, there are polarised effects from classifying
those claim as liabilities or equity (IASB, 2016b, para 11). The Board
acknowledges that it is impossible for a single distinction between liabilities and
equity to convey all the similarities and differences between claims and is
therefore working on deciding what information is best provided using the
liabilities/equity distinction; and what information is best provided through
disclosure and presentation of subclasses and by other means (such as EPS)
(IASB, 2016b, para 13).
In discussions thus far, the Board proposes the separate presentation of
liabilities that depend on a residual amount (IASB, 2016b, para 31).44 The
separate presentation requirements will apply to stand-alone and embedded
derivatives that depend on a residual amount, with related income and expense
in OCI. This approach will provide additional information about liabilities,
while avoiding some of the pitfalls of the mezzanine approach.
The Board is proposing presentation of subclasses of equity,45 with the
attribution of some income (recognised in profit or loss or OCI) to other classes
of equity than ordinary shares.46 The carrying amount of subclasses of equity
will be updated to reflect attribution. In addition, there will be separate
presentation of derivatives on own equity and separate presentation of income
and expense arising from these derivatives (or just the income and expense
43
For example, liabilities that have payments that are a function of the fair value of an
entity’s ordinary shares.
44
For example, obligations to transfer an amount of cash equal to the fair value of an
entity’s ordinary shares.
45
The new subclasses of equity and liabilities will, if combined, be similar to the
mezzanine category referred to in Section 5.4.
46
While the Board’s discussions have included consideration of different methods that
could be used to measure this attribution for the various types of equity instruments, it
has not given any indication of how or where this attribution will be presented.

arising on the portion dependent on residual amount) (IASB, 2016b, para 45–
46).
A recurring comment in the summary presented in Appendix 3 is that there is
limited information provided on the future potential dilutive effects of the
various instruments listed. The Board’s suggestions with regard to income
attribution would go some way towards remedying this problem, depending on
the method chosen. The preferred method for nonderivative instruments,
however, is based on the outdated and simplistic methods of IAS 33. Despite
these changes, the challenges around valuing nontraded instruments and
components are likely to remain.
The Board also intends to require additional disclosures relating to features
of instruments such as type, timing, amount (quantity) and priority (seniority/
rank). The information should assist users to determine whether the entity has
sufficient resources to meet obligations, and whether the entity has produced
sufficient returns to meet claims (see discussion in Section 5.3). Thus, the
standard setters’ initiatives go some way to addressing the weaknesses in
accounting for compound instruments we have previously highlighted.
The Board has discussed using a mezzanine category, but it is not presently
under consideration. In the Framework project, the IASB concluded that the
introduction of another element between liabilities and equity was not
appropriate (IASB, 2015, para BC4.96 and BC94.97) and it was not clear
that the use of a mezzanine would provide more benefits than disclosures about
subclasses of liabilities and equity. They stated that adding another element
would make the classification and resulting accounting (and profit or loss
treatment) even more complex than is the case currently (IASB, 2015, para
BC4.97).47
We are unsure about the effects of the changes being contemplated by the
IASB on the accounting described for the examples in Table 5. Under the
IASB’s Gamma approach, we expect that the classification of the instruments
in the table would be much the same as under IAS 32 (except for the long-dated
redeemable preference shares, which would probably be classified as a liability
in its entirety under the Gamma approach). However, there is a risk that
unintended consequences may arise from the application of the new underlying
principles. As mentioned above, the IASB also intends to separately present
those liabilities that depend on a residual amount, for example units issued by
limited life trusts. Income and expenses that arise from these types of liabilities
would also be presented separately in other comprehensive income. In
47
The IASB’s conclusion was criticised by some of the respondents to the Framework
ED. The Accounting Standards Board of Japan thought that use of a mezzanine
category remained the best way to deal with the complexities associated with compound
instruments (ASBJ, 2015, p. 52). The Asian-Oceanian Standard Setters Group also
believed that the ‘three-category approach’ had been dismissed prematurely (AOSSG,
2015, p. 23).

conclusion, we expect some changes (and improvements) to the accounting

observed on the examples outlined in Table 5. However, many of the
comments in Table 5 remain applicable.
6. Conclusion
Accounting for compound financial instruments, that is those with charac-

teristics of both debt and equity, presents challenges for standard setters and
practitioners. Our study adds to the literature on this topic by providing an
overview of the nature of the problem, the scope of research evidence and
possible future actions available to standard setters.
We outline the definitions of liabilities and equity in the Framework and IAS
32 and discuss problems arising in practice from the definitions and the
principles for classification of equity and nonequity financial instruments. We
also present relevant academic research on this topic. Most studies are based on
US firms, and their findings may not be generalisable to IFRS adopting firms.
Some studies suggest the requirements of accounting standards influence firms’
choices regarding financing structure and instruments. Other studies consider
the impact of classification on investors’ decision-making. However, we do not
find studies investigating how firms apply the classification rules in accounting
standards, which would be useful to standard setters for their deliberations on
this topic. We discussed four approaches the standard setters could use in
further work on the topic and highlighted various limitations in the current
approaches. We then linked this discussion to the current work of the IASB, to
determine the extent to which their current approaches will address the
problems we document. We conclude that the current work has the potential to
improve the application of IAS 32 through enhanced presentation and
disclosure, but underlying issues relating to judgements and estimates in
valuation will remain.
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Appendix 1
Accounting standards relevant to financial instruments
IAS 32 financial instruments: presentation

Reissued December 2003. Applies to annual periods beginning on or after 1 January 2005
Outlines the requirements for presentation of financial instruments, particularly the classification of
such instruments into financial assets, financial liabilities and equity instruments. Provides
guidance on classification of interest, dividends and gains/losses and when financial assets and
liabilities can be offset
Amended in February 2008 for puttable instruments and obligations arising on liquidation.
Following the amendment, some financial instruments that meet the definition of a financial
liability will be classified as equity because they represent the residual interest in the net assets of
the entity (IAS32:16A-D)
Amended in October 2009 for classification of rights issues. The amendment states that if rights
relating to a fixed amount of foreign currency are issued pro rata to all existing shareholders (in the
same class) for a fixed amount of currency, then they should be classified as equity
Source: http://www.iasplus.com/en/standards/ias/ias32
IAS 39 financial instruments: recognition and measurement

Reissued December 2003. Applies to annual periods beginning on or after 1 January 2005. Largely
replaced by IFRS 9 for periods beginning on or after 1 January 2018
Outlines the requirements for the recognition and measurement of financial assets, financial
liabilities, and some contracts to buy or sell nonfinancial items. Financial instruments are initially
recognised when an entity becomes party to the contractual provisions of the instrument and are
classified into various categories depending upon the type of instrument, which then determines
the subsequent measurement of the instruments (typically amortised cost or fair value). Special
rules apply to embedded derivatives and hedging instruments
Source http://www.iasplus.com/en/standards/ias/ias39
IFRS 7 financial instruments: disclosures

Issued August 2005. Applies to annual period beginning on or after 1 January 2007
Requires disclosure of information about the significance of financial instruments to an entity, and
the nature and extent of risks arising from those financial instruments both in qualitative and
quantitative terms. Specific disclosures are required in relation to transferred financial assets and a
number of other matters
Source: http://www.iasplus.com/en/standards/ifrs/ifrs7
IFRS 9 financial instruments

Issued July 2014. Applies to annual period beginning on or after 1 January 2018. Early adoption
permitted
Includes requirements for recognition and measurement, impairment, derecognition and general
hedge accounting
Replaces IAS 39, but does not replace the requirements for portfolio fair value hedge accounting for
interest rate risk (macro hedge accounting)
Source: http://www.iasplus.com/en/standards/ifrs/ifrs9

Appendix 2
Summary of liability and equity classification under IAS 32 and IFRS 2
IAS32 IFRS2
Liabilities • Obligation to deliver cash or • Obligation to transfer cash

another financial asset† or other assets
• Obligation (in a derivative or non-
derivative) to deliver a variable
number of the entity’s own equity
instruments
• Obligation (in a derivative only)
that may or must be settled by
exchanging a fixed number of the
entity’s own equity instruments for
a variable amount of cash or other
financial assets
• Derivative obligation that allows
either the holder or issuer to elect
whether the holder is to settle in
cash or in shares
Equity • No obligation to deliver cash or • No obligation to transfer

other financial assets (and none of cash or other assets
the above features present) • No obligation for the entity
• Some puttable instruments that at all because another group
entitle the holder to a pro rata share entity or other related party
of net assets on liquidation, or will settle the obligation
earlier repurchase
• Obligation to deliver a pro rata
share of net assets only on liquida-
tion of the entity
• Derivative that must be settled by
exchanging a fixed number of the
entity’s own equity instruments for
a fixed amount of cash or other
financial assets
†
Or to exchange financial assets or financial liabilities under conditions that are potentially
unfavourable.
Source: Discussion Paper DP/2013/1 A Review of the Conceptual Framework for Financial
Reporting (IASB, 2013, p. 93).

Appendix 3
36
Australian companies: Examples of the use of non-traded convertibles and the typical accounting treatment
This table shows a selection of non-traded convertibles randomly chosen (using a random seed generator) from the
hybrid instruments listed in the Issued Capital section of the Morningstar Datanalysis database on the 18 August 2016.
Securities issued under the following codes were included in the list; BND, CNV, COP, FRN, MTN, NIS, PRF, RGT,
RGTS, UNS, WGT and WNT. Additional examples were extracted from some of the larger financial institutions given
their dominance in the listed hybrids market. For each instrument selected the annual report was drawn from the
company’s website (or ASX website if this was not available) and the accounting treatment of and disclosure related to the
instrument recorded. Comments and observations are given on the quality of financial information and potential challenges
that may arise.
Type of Instrument
Issued Example companies Accounting treatment Disclosure Comments/Observations
Compensation related
Call options as part of Electro Optic Systems Equity-settled share- Remuneration report Key inputs used in
employee or director Holdings Limited based payment and note disclosure of valuation generally not
remuneration (Annual Report 31 total shares under based on traded market
December 2015) Lithium options outstanding, data. Limited details on
Power International remuneration expense vesting conditions
Limited Windward for the year, shares provided. Disclosure of

Resources Ltd Datetix issued from the exercise potential dilutive effects
Group Ltd Chesser of options, method limited to diluted EPS
Resources Limited used to value options and exercise price. No
Adavale Resources and inputs used disclosure of change in

Limited Vocus value for the year
Communications Limited
(Annual Report 30 June
2016)
(continued)
Table (continued)
Type of Instrument
Performance rights Genworth Mortgage Equity-settled share- Remuneration report Key inputs used in
issued as part of Insurance Australia based payment and note disclosure of valuation generally not
employee remuneration Limited (Annual Report rights outstanding, based on traded market
31 December 2015) remuneration expense data, although this is
Mirvac Group Senetas for the year, shares less significant than
Corporation Limited issued from the exercise with option valuation.
Cleanaway Waste of rights, method used Reasonable disclosure
Management Limited to value rights and of vesting conditions.
Vocus Communications inputs used Very little disclosure
Limited (Annual Report provided in interim
30 June 2016) Ambition report and
Group Limited announcements for
(Appendix 4D - Interim recently issued rights
Report 30 June 2016,
Annual report 31
December 2015 and
Appendix 3B 18 February
2016) Zyber Holdings Ltd
(Appendix 3B 5 July 2016)
Loan funded share plan Vocus Communications Employees are granted Remuneration report Limited information
as part of employee Limited (Annual Report limited recourse loans and note disclosure of provided on accounting
remuneration 30 June 2016) to acquire shares in nature and structure of treatment applied.
the listed entity, but plan, shares held by Assume equity-settled
the shares are held by and loans owing from share-based payment
a subsidiary until employees under the using embedded option

specified conditions plan, shares held by the value. Diluted earnings
have been met and the subsidiary, per share treatment not
(continued)
37
Table (continued)
38
Type of Instrument
loan has been repaid. remuneration expense disclosed and limited

Shares held by the for the year, shares information provided to
subsidiary are treated issued via the plan, assess dilutive effect of
as treasury shares (and issue price and fair plan
deducted from value per share
contributed equity)
Business combinations and equity
Performance shares Datetix Group Ltd Part of purchase Note disclosure of No subsequent
issued as part of a (Annual Report 30 June consideration. settlement date, rights revaluation of shares
business combination. 2016) Convert into ordinary by class of issue, and because part of equity.
shares when share features including As a result no
price reaches a vesting. Disclosure of subsequent information
prescribed level and method used to value on accuracy of initial
certain business shares and inputs used fair value calculation
performance
thresholds are met.
Credit taken to equity
reserve
Call options issued as Datetix Group Ltd Fair value shown as Cost of share issue. Disclosure of potential
equity raising fee (Annual Report 30 June reduction of ordinary Disclosure of method dilutive effects limited
2016) share capital and used to value shares to diluted EPS and
increase in equity and inputs used. exercise price. No
reserve Assumption regarding disclosure of change in
exercise dates value for the year

Performance shares Zyber Holdings Ltd Performance shares Disclosure in Confusing comments
issued as part of reverse (Annual Report 30 June issued as part of prospectus. Note made about the
acquisition 2016 and Prospectus 30 consideration for disclosure of shares accounting treatment;
November 2015) reverse acquisition. issued and at one point in the
(continued)
Table (continued)
Type of Instrument
No separate entry for performance report it states that the

the issue of these conditions required to shares are valued at nil
rights (valued at nil) be met whereas another section
states that the fair value
of the shares has been
included in the purchase
consideration for the
transaction
Exchangeable shares Zyber Holdings Ltd Preference shares issued Disclosure in This type of interest
issued as part of reverse (Annual Report 30 June by a subsidiary to prospectus. Note would normally be
acquisition 2016 and Prospectus 30 previous shareholders disclosure of shares shown as minority
November 2015) of the legal acquiree as issued and terms of interests. Perhaps
part of the reverse exchange shown as part of
acquisition. Equity- reserves in this case as
settled share-based the shares can be
payment (issued shares converted into holding
included as part of company shares at any
reserves) time
Call options issued as Zyber Holdings Ltd Options issued to Disclosure in Limited description of
part of reverse (Annual Report 30 June replace warrants prospectus. Note accounting treatment
acquisition 2016 and Prospectus 30 issued by legal disclosure of options and reason for issuing
November 2015) subsidiary. No issued and inputs used options in annual
separate entries for the to value options report. Fair value of
replacement options options shown in

(valued at nil) annual report different
(continued)
39
Table (continued)
40
Type of Instrument
to the value disclosed in

the prospectus
Call options and Vocus Communications Equity-settled share- Remuneration report Key inputs used in
performance rights Limited (Annual Report based payment. Value and note disclosure of valuation generally not
issued to replace 30 June 2016) of options and rights rights/options issued, based on observable
existing instruments as allocated between options outstanding, data. Disclosure of
part of a business purchase remuneration expense potential dilutive effects
acquisition consideration and for the year, shares limited to diluted EPS
post-combination issued from the exercise and exercise price. No
remuneration of rights/options, and disclosure of change in
method used to value value for the year
rights/options
Equity raising
Subordinated IAG Limited (Annual Classified as debt. Note disclosure of Disclosure of potential
convertible notes, report 2016) Recorded initially at details of instruments dilutive effects limited
bonds, debt fair value then at including conversion to “if converted”
amortised cost features method for diluted EPS
Call options issued as Jacka Resources Limited No separate entries for Directors’ report and No details of accounting
free attaching options (Annual Report 30 June the options. Only the note disclosure of for options provided.
to share issue 2016, Notice of Annual share issue recognised options granted and Disclosure of potential
General Meeting 24 total options dilutive effects limited
November 2015, and outstanding to diluted EPS and
Appendix 3B 8 December exercise price. No
2015) disclosure of change in

Lithium Power value for the year
International Limited
(continued)
Table (continued)
Type of Instrument
(Annual Report 30 June

2016)
Convertible loan from Adavale Resources Limited Split into a debt and Note disclosure of Key inputs used in
significant investor (Annual Report 30 June equity component. details of instrument. valuing debt and equity
2016) Debt component In this case the loan component generally
calculated by using a accrues interest at 8%, not based on observable
notional interest rate is repayable within data. Disclosure of
of 30%. Interest 24 months, unsecured potential dilutive effects
accrued in income and convertible into a limited to “if
statement based on fixed number of shares converted” method for
notional interest diluted EPS. No
disclosure of change in
value of equity
component for the year
Capital raising facility Adavale Resources Limited No separate recognition Note disclosure of No dilution in EPS
(Annual Report 30 June of the facility. Show details of capital calculation as facility
2016) issued shares at raising facility. In this not considered dilutive.
proceeds received case a facility of No details of
$1,000,000 over consideration given for
5 years. At each draw facility

down of the facility,
shares are issued at
80% of 5 day VWAP
Convertible adjustable Ramsay Health Care Classified as equity - Note disclosure of Core EPS reported after

rate equity securities (Annual report 2016) non-cumulative instrument features CARES dividends. No
(CARES) redeemable preference including dividend rate disclosure of change in
value for the year.
(continued)
41
Table (continued)
42
Type of Instrument
shares, distributions calculated as a market Disclosure of potential

classified as dividends rate plus margin dilutive effects limited
to “if converted”
method for diluted EPS
Purchase of services:
Call options as Kogi Iron Limited Equity-settled share- Directors’ report and Key inputs used in
payment for services Lithium Power based payment note disclosure of total valuation generally not
rendered by advisor/ International Limited shares under option based on observable
consultant (Annual Report 30 June outstanding, expense data. Disclosure of
2016) for the year, shares potential dilutive effects
issued from the exercise limited to diluted EPS
of options, method and exercise price. No
used to value options disclosure of change in
and inputs used value for the year
Bank capital management
Convertible Preference Westpac (Annual report Classified as debt Features disclosed Part of bank tier 1
Shares 2016) Adelaide and within the balance including conversion capital. May or may not
Bendigo Bank (Annual sheet and dividends to triggers, cum dividend, provide fair value in
Report, 2016) the holders are treated interest rate addition to amortised
National Australia Bank as interest. Recorded information cost. Disclosure of
(Annual report 2016) initially at fair value potential dilutive effects

then at amortised cost limited to “if
converted” method for
diluted EPS (if not
carried at fair value)

Appendix 4
Bibliography of selected relevant literature
Paper Objective Key conclusions
Panel A Commentary and fundamental analysis

Various comments and analyses of the accounting standards related to the distinction between liabilities and equity
Dutordoir et al. (2014) Review of the literature on the motives for Studies of the issuance of convertible debt typically focus on
issuance, the shareholder wealth effects, testing the predictions from four traditional theoretical models
and the design of convertible bonds based on convertibles’ potential to mitigate agency or adverse
selection costs. The studies provide mixed evidence
Studies on the determinants of convertible bond design
indicate earnings management as an important determinant of
innovations in the characteristics of convertible bonds
Schmidt (2013) Comments on the IASB and FASB Some hybrid instruments are designed to exploit the current
approach to distinguishing between classification approach
liabilities and equity The classification approach does not always result in decision-
useful information
A reconsideration of the traditional dichotomous liability/
equity classification might be a way forward
Hopkins et al. (2009) AAA FRC response to FASB’s The principles underlying the basic ownership approach are not
preliminary views clearly defined, are not appropriate given the extant
conceptual framework and will not simplify accounting for

instruments that are within the scope of the preliminary views
FASB (2007) Summary of FASB’s views on Preliminary view that the basic ownership approach provides
distinguishing between equity and more decision-useful information to investors and would
liabilities or assets simplify accounting requirements for issuers and their auditors

Three approaches are described: basic
(continued)
43
44
Table (continued)
ownership, ownership-settlement and

reassessed expected outcomes
Bishop et al. (2005) Assess the impact of IAS 32 on the IAS 32 would result in higher amounts for liabilities and higher
financial reporting of convertible interest
financial instruments by retrospective Analysts using financial statement information to assess risk of
application of the standard to a sample financial distress will need to revise the critical values of
of New Zealand companies over the commonly used measures of risk and performance
period 1988–2003
Ohlson and Penman Presents an accounting model for claims Present a proposal for a comprehensive and unified treatment
(2005) with payoffs dependent on the stock price for all stock price performance-contingent claims from the
perspective that performance-contingent claims should not be
recognised as equity and should be recognised as liabilities
measured at fair value
Botosan et al. (2005) Summarises conceptual issues that arise in Highlight the inconsistencies and controversies surrounding
the definition, recognition, existing accounting standards for liabilities, and describe the
derecognition, classification, and research evidence that provides insights into accounting for
measurement of liabilities liabilities
Ryan et al. (2001) AAA FRC comments on the FASB’s The exposure draft approach:
exposure draft, ‘Accounting for decreases the usefulness of the balance sheet for assessing
Financial Instruments With solvency and valuing residual claims,
Characteristics of Liabilities, Equity, or does not clearly link the balance sheet to the income statement,
Both’ the classification of hybrid and inseparable compound

(continued)
Table (continued)
financing instruments relies on contractual provisions rather

than economic substance,
does not properly reflect the probabilities that these
instruments will be settled as equity or debt
Paper Research question Sample Main findings
Panel B Capital markets evidence

These papers investigate the incentives to issue compound instruments; the effect of accounting standards on what instruments are issued, how those
instruments are structured and the quality of disclosure. Papers on the market’s reaction and response to compound instruments are included
Levi and Segal (2015) Examine the influence of classification of US The proportion of MRPS issuances in
mandatorily redeemable preferred shares All firms listed on NYSE, firms’ new financing declined following
(MRPS) into liabilities and equity on AMEX and NASDAQ the introduction of SFAS 150
firms’ financing choices following the (excluding ADRs and Banks) The requirement to classify debt-like
introduction of SFAS 150 1981–2011 hybrids as a liability reduced the
reporting incentives for issuance and
made these securities a less popular
financing vehicle
Lewis and Verwijmeren Examine the consequences of changes to US Shareholders of firms that use cash-settled
(2014) the accounting treatment of cash-settled 179 firms that issued convertibles reacted negatively to the
convertibles in the calculation of diluted convertible bonds announcement of the accounting changes
earnings per share 2000–2007 mandated by APB 14-1
Investors responded more favourably if
the convertibles include call features as

these allow the firm to efficiently mitigate
(continued)
45
46
Table (continued)
the effects of the accounting changes on

their financial reporting
Lopez-Espinosa et al. Examine the impact of classification Six European countries, U.S. Criteria for classification based on
(2012) approaches under discussion by the and Canada ownership should take account of the
IASB and FASB for co-operative fact that ownership is multidimensional
member shares with varying and contingent on the type of firm
characteristics
Moser et al. (2011) Examine the relation between accounting- US Firms’ financial covenants affect their
based debt contracts and the economic 58 firms choice to redeem versus reclassify their
response of firms with trust preferred All industrial firms with outstanding TPS
stock (TPS) to mandated liability outstanding TPS in 2002 Firms are significantly more likely to
recognition under SFAS 150 1993–2005 redeem rather than reclassify their TPS
after FAS 150 if they used the original
TPS proceeds to retire existing debt
Lewis and Verwijmeren Examine how firms choose fixed income US Fixed income claims are chosen to reduce
(2011) claims and the method of payment for 814 convertible security issues corporate income taxes, minimise
convertible securities 2000–2007 refinancing costs, and help mitigate
managerial discretion costs
Method of payment choice frequently
includes cash settlement features because

they increase reported diluted earnings
per share
Scott et al. (2011) Examine whether firms issuing convertible Canada Payment-in-kind (PIK) provisions
debt structured these issuances to reduce 195 convertible debt offerings allowed firms to classify a significant
the leverage reported 1996–2003 portion of the proceeds of convertible

debt issuances as equity
(continued)
Table (continued)
Highly-leveraged firms with material

convertible debt transactions were more
likely to use PIK provisions
The use of PIK provisions declined
following the introduction of more
restrictive accounting
Godfrey et al. (2010) Investigate the systematic risk effect of Australia Firms’ systematic risk is significantly
introducing an accounting standard 240, 398 and 402 firms for the lower after the adoption of the new
(AASB 1033) that required the three different time periods standard
classification of hybrid securities 1995–1998 Results consistent with the new
according to their economic substance accounting classification rules providing
rather than their legal form more transparent information to
investors and a reduction in information
asymmetry
Lee et al. (2009) Study the association between investor Listed firms from 19 countries Firms in countries with stronger
protection and security design of 936 firm-year observations shareholder (creditor) rights issue
convertibles 1995–2005 convertible debt with a higher (lower)
expected probability of converting to
equity
The probability of conversion is lower

for firms with higher separation of
control rights and cash-flow rights
Marquardt and Examine the economic consequences of US Issuers are more likely to restructure or
Wiedman (2007b) changes in the financial reporting 199 firms that issued COCOs redeem existing COCOs to obtain more
requirements for contingent convertible 2000–2004 favourable accounting treatment when

securities (COCOs) the financial reporting impact on diluted
(continued)
47
Table (continued)
48
EPS is greater and when EPS is used as a

performance metric in CEO bonus
contracts
Evidence of significantly negative stock
returns around dates associated with the
financial reporting changes, consistent
with investor anticipation of the agency
costs associated with the changes
Marquardt and Study the quality of disclosures related to US Find that prior to 2004 there was
Wiedman (2007a) contingently convertible securities 202 firms that issued COCOs inconsistent and inadequate disclosure of
(COCOs) 2000–2004 the information necessary to undo the
financial reporting effects of COCOs.
Disclosure quality improved after the
introduction of FASB Staff Position 129-
a, requiring firms to disclose the terms of
COCOs. Managerial incentives influence
disclosure quality in both disclosure
regimes
Terando et al. (2007) Examine whether investors’ valuations of US Market participants value cash and share-
cash and share-put warrants are 156 firm-year observations for puts differentially based on their solvency
influenced by their potential differential 52 firms that issued puts characteristics
effect on firm solvency 1991–2003 Complex financial instruments such as

cash and share-puts should be reported
separately
Suchard (2007) Examines announcements of rights issues Australia Results suggest convertible debt issues
of convertible debt 58 convertible debt issues best explained by information

1980–2002 asymmetry hypothesis proxied by firm
risk, stockholder participation and
(continued)
Table (continued)
institutional holding and agency costs

proxied by underwriter costs.
Convertible debt issues by resource firms
have a less negative announcement
return
Suchard and Singh Examines the determinants of security Australia The results support the pecking order
(2006) choice for hybrid issuers in the 57 convertible debt issues model and the impact of financial distress
Australian market 147 warrant issues costs and taxation. The results also
25 preference share issues provide some support for the sequential
1980–2002 financing model where firms with high
profitability use convertible debt and
firms with low profitability use warrants
De Jong et al. (2006) Investigate the impact of IAS 32 on Netherlands The reclassification resulting from the
preference shares 34 firms with outstanding introduction of IAS 32 will on average
preferred stock increase the reported debt ratio by 35%
2004 Of the firms that are affected by IAS 32,
71% buy back their preference shares or
alter the specifications of the preference
shares in such a way that the
classification as equity can be maintained
Marquardt and Examine whether firms structure their US The likelihood of firms issuing contingent
Wiedman (2005) convertible bond transactions to manage 207 firms with convertible convertible bonds (COCOs) is associated
diluted earnings per share (EPS). bond offerings with the reduction that would occur in
2000–2002 diluted EPS if the bonds were
traditionally structured
The likelihood of COCO issuance is

associated with the firms’ use of EPS-
based compensation contracts
(continued)
49
Table (continued)
50
Cheng et al. (2003) Examine the economic substance of a US Redeemable preferred securities (including
broad range of securities by investigating 2617 firms that reported trust preferred stock) are not viewed by
their association with systematic risk and minority interests or preferred the market as either debt or equity
prices stock Nonredeemable preferred stock and
1993–1997 minority interests are viewed as debt-like
and equity-like respectively (in contrast
to their accounting treatment)
Engel et al. (1999) Examine issues relating to trust preferred US Firms are willing to incur significant direct
stock (TPS): the extent to which 158 TPS issuances and opportunity costs to obtain a
managements will incur costs to manage 1993–1996 favourable balance sheet classification
the balance sheet classification of a Firms issuing trust preferred stock and
security, the net tax benefits and the retiring traditional preferred stock are
impacts on investor-level taxation able to achieve substantial tax savings
Investor-level taxation has little effect on
the equilibrium pricing of these securities
Lee and Figlewicz (1999) Examine the characteristics of firms that US Convertible preferred stock issuing firms
issue convertible debt compared to firms 308 convertible debt and have larger nondebt tax shields, higher
that issue convertible preferred stock preferred stock offerings levels of financial, operating, and
1977–1988 bankruptcy risks, greater free cash flow
and more potential for growth than firms
issuing convertible debt
Kimmel and Warfield Investigate the economic substance of US Despite mandatory redemption payments,
(1995) redeemable preferred stock (RPFD) by 239 firms with RPFD RPFD does not have a debt-like impact
examining the relationship between firm outstanding between on systematic risk
leverage and systematic risk 1979–1989 Dichotomous classification of hybrid
securities does not faithfully represent

the economic substance of these
securities
(continued)
Table (continued)
King and Ortegren Consider the accounting consequences of US ARCNs were designed to achieve
(1988) adjustable rate convertible notes Four ARCN issues minimum increases in balance sheet debt
(ARCNs) 1982 & 1983 Propose an approach to accounting for
ARCNs and other hybrid financial
instruments that focuses on the substance
of the instruments
Panel C User perceptions
These papers consider how users interpret information about compound instruments. This is done within the context of experienced finance professionals
and financial analysts
Clor-Proell et al. (2016) Study whether the features of hybrid US The classification as liability or equity is
instruments affect the credit-related 162 and 56 responses for the not of primary importance as these users
judgments of experienced finance two experiments largely made their judgments on the basis
professionals Respondents from alumni of the underlying features of the
with banking, finance or instrument
related experience. Experienced users vary in their beliefs
about which features are most important
in distinguishing between liabilities and
equity
The results highlight the need for
effective disclosure of the features of

hybrid instruments
da Costa Jr et al. (2016) Evaluate the effect of balance sheet Brazil Analysts are likely to treat compound
classification of a compound financial 84 analysts (37 sell-side and 47 financial instruments conservatively as a
instrument on securities market analysts’ buy-side) liability, regardless of the classification

estimation of target prices of a company on the balance sheet
(continued)
51
52
Table (continued)
Hopkins (1996) Investigate whether the balance sheet US Differential accounting classification
classification of mandatorily redeemable 83 buy-side financial analysts affects the stock price judgments of
preferred stock (MRPS) affects the stock financial analysts
price judgments of buy-side financial Analysts predicted significantly higher
analysts common stock prices if the MRPS was
classified as a liability
If the MRPS was classified as mezzanine,
the analysts used a more attribute-based
process to determine the stock price
This appendix provides details of a selection of papers relevant to the topic of debt-equity classification of compound financial instruments.
Papers are grouped into three panels. Panel A includes key commentary papers. Panel B includes capital markets studies including the effect of
accounting standards on: which instruments are issued, how they are structured and how they are presented. Panel C includes studies of user
perceptions of classifications.

Accounting For Nancial Instruments With Characteristics of Debt and Equity: Nding A Way Forward

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Accounting & Finance

Accounting for ﬁnancial instruments with characteristics

Neil Farghera, Baljit K. Sidhub, Ann Tarcac, Warrick van Zylc

Accounting for compound ﬁnancial instruments, that is those with character-

Key words: Compound instruments; Equity; Hybrid; IAS 32; Liabilities

JEL classiﬁcation: M41, M48

© 2018 Accounting and Finance Association of Australia and New Zealand

Distinguishing between the elements of liabilities and equity is a fundamental

© 2018 Accounting and Finance Association of Australia and New Zealand

© 2018 Accounting and Finance Association of Australia and New Zealand

compound instruments. Therefore, we also identify areas where further

2. Defining debt and equity

2.1. Guidance from the Framework

The Framework lists the ﬁve elements of ﬁnancial statements: assets,

© 2018 Accounting and Finance Association of Australia and New Zealand

2010a, para 4.4(c)). Therefore, the classiﬁcation of items as liabilities also

2.2. Accounting standards guidance and deﬁnitions

There are two characteristics of ﬁnancial instruments that are commonly

© 2018 Accounting and Finance Association of Australia and New Zealand

A ﬁnancial liability is any liability that is:

a to deliver cash or another ﬁnancial asset to another entity or

Framework compared to IAS 32 results in diﬀerent accounting outcomes (see

© 2018 Accounting and Finance Association of Australia and New Zealand

the Framework, as discussed above. However, International Accounting

3. Extent of use of compound instruments and practical issues

3.1. Extent of use

In Australia, the use of compound ﬁnancial instruments is small but growing,

© 2018 Accounting and Finance Association of Australia and New Zealand

Source: IAS 32; Deloitte (2016) http://www.iasplus.com/en/standards/ias/ias32.

convertible or converting debt securities, preference shares and capital notes

© 2018 Accounting and Finance Association of Australia and New Zealand

2016 33.4 1.1 34.5 1728

3.2. Issues in practice

Examples of classiﬁcation issues in practice are shown in Table 5. Securities

© 2018 Accounting and Finance Association of Australia and New Zealand

to identifying or valuing the components or determining the treatment of an

© 2018 Accounting and Finance Association of Australia and New Zealand

© 2018 Accounting and Finance Association of Australia and New Zealand

To extend the examples provided in Table 5, Appendix 3 shows a range of

4. Insights from research

In this section, we discuss studies on compound ﬁnancial instruments.19

© 2018 Accounting and Finance Association of Australia and New Zealand

Compound instrument Key terms/features Classiﬁcation under IAS 32 Comments

© 2018 Accounting and Finance Association of Australia and New Zealand

Compound instrument Key terms/features Classiﬁcation under IAS 32 Comments

• Converts into ordinary shares on small. In this case, this clause

© 2018 Accounting and Finance Association of Australia and New Zealand

Compound instrument Key terms/features Classiﬁcation under IAS 32 Comments

the paragraph 16E exemption

© 2018 Accounting and Finance Association of Australia and New Zealand

There is an extensive literature on how companies select ﬁnancing

© 2018 Accounting and Finance Association of Australia and New Zealand

parent-subsidiary directive in 2014. Diﬀerences in tax law internationally

4.2 The eﬀect of classiﬁcation on the decision-making of users

Classiﬁcation is important because it has the potential to aﬀect the decision-

© 2018 Accounting and Finance Association of Australia and New Zealand

Proell et al. (2016) used an experiment to test how experienced US ﬁnance

© 2018 Accounting and Finance Association of Australia and New Zealand

4.3. Future research

We have discussed research that is relevant to the understanding the eﬀects of

© 2018 Accounting and Finance Association of Australia and New Zealand

the effect of classification into the elements (liabilities, equity) on financing

5. Responses to the classification problem