IAS 32 Debt or Equity: Why the Same Preference Share Can Land in Three Different Places

Issue a million pounds of preference shares. Depending on who controls the dividend and who controls the redemption, the same instrument with the same cash flows can be wholly equity, wholly a liability, or split between the two with a liability of £680,583 and equity of £319,417. The legal form is identical in all three cases.

That is IAS 32 Financial Instruments: Presentation, and paragraph 18 states the principle in one line: the substance of a financial instrument, rather than its legal form, governs its classification.

The two-condition test

Paragraph 11 defines an equity instrument as any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Paragraph 16 then provides that an instrument is an equity instrument if, and only if, both of two conditions are met.

The first is that there is no contractual obligation to deliver cash or another financial asset, or to exchange financial assets or liabilities under potentially unfavourable conditions. The second is that where the instrument will or may be settled in the entity own equity instruments, it is either a non-derivative including no contractual obligation to deliver a variable number of them, or a derivative settled only by exchanging a fixed amount of cash or another financial asset for a fixed number of them.

Paragraph 17 names the decisive feature: a critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation. Paragraph 19 completes it: if the entity does not have an unconditional right to avoid delivering cash or another financial asset, the obligation is a financial liability. An obligation conditional on the counterparty exercising a redemption right still counts.

Economic compulsion is not an obligation

This is the first place practitioners go wrong, and the standard addresses it directly. An entity may feel it has no realistic choice but to pay a dividend. That is not an obligation for IAS 32 purposes.

The application guidance lists six factors as irrelevant to classification: a history of making distributions, an intention to make distributions, a possible negative impact on the ordinary share price, the amount of reserves, an expectation of profit or loss for a period, and the ability or inability to influence profit or loss. The Board has confirmed that a contractual obligation may be established explicitly or indirectly, but it must be established through the terms and conditions of the instrument, and that by itself economic compulsion would not result in a financial instrument being classified as a liability.

Reputational pressure and a dividend stopper are not terms of the instrument. Read the contract.

Fixed for fixed, and why foreign currency breaks it

Paragraph 21 is blunt: a contract is not an equity instrument solely because it may result in the receipt or delivery of the entity own equity instruments. A contract to deliver as many of its own shares as equal £100 in value is a financial liability, because the entity uses a variable number of its own equity instruments as a means to settle the contract.

Paragraph 22 gives the converse. A contract settled by delivering a fixed number of own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. Consideration received, such as the premium on a written warrant over own shares, is added directly to equity; consideration paid is deducted directly from equity; and changes in the fair value of an equity instrument are not recognised in the financial statements at all. Paragraph 24 mirrors paragraph 21: a fixed number of shares for a variable amount of cash is a financial asset or liability.

Now the point worth knowing for any group with cross-border funding. A fixed amount of foreign currency is not a fixed amount of cash. So a convertible bond denominated in a currency other than the issuer functional currency fails fixed for fixed and carries a derivative liability rather than an equity conversion option. The IFRIC recommended changing this in June 2005 and in September 2005 the Board decided not to proceed with an amendment, so the position has stood for two decades.

There is one carve-out, in paragraph 16(b)(ii): rights, options or warrants to acquire a fixed number of own equity instruments for a fixed amount of any currency are equity, provided they are offered pro rata to all existing owners of the same class of non-derivative equity instruments. That is the rights issue exception, and it is narrow.

Obligations to buy your own shares

Paragraph 23 catches a transaction many groups do not expect to be caught by. An obligation to purchase own equity instruments for cash gives rise to a financial liability for the present value of the redemption amount, and this is the case even if the contract itself is an equity instrument. The liability is reclassified out of equity. It applies even where the obligation is conditional on the counterparty exercising a right to redeem, which is the written put over a non-controlling interest.

That is one of the areas the IASB Financial Instruments with Characteristics of Equity project is intended to address. A note of caution, because commentary often overstates this: as at late 2026 nothing has been issued. The exposure draft was published in November 2023, comments closed in March 2024, and the Board was still redeliberating in September 2026 with the next milestone listed as final amendments and no date given. Do not plan around it. Note too that the exposure draft targeted IAS 1, which IFRS 18 replaces from 2027, so the eventual package will likely land elsewhere.

Split accounting: measure the liability first

Paragraph 29 treats a bond convertible by the holder into a fixed number of ordinary shares as a compound instrument: a financial liability plus an equity instrument, being a call option granting the holder the right to convert.

Paragraph 31 sets out the residual method. The equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. The sum of the two always equals the fair value of the whole, and no gain or loss arises from initially recognising the components separately. Paragraph 32 confirms the order: the liability is measured first, as the fair value of a similar liability without an associated equity component.

Measuring the option by an option-pricing model and plugging the liability is the wrong way round. And under paragraph 30 the allocation is never revised for changes in the likelihood of conversion.

Worked example: a convertible bond

On 1 January 20X1 an entity issues £10,000,000 of 5 per cent convertible bonds at par, interest paid annually in arrears, redeemable at par on 31 December 20X3 or convertible at the holder option into 2,000,000 ordinary shares of 25p. The market rate for a similar bond without the conversion option is 8 per cent.

Discount the contractual cash flows at 8 per cent. Interest of £500,000 for three years at an annuity factor of 2.577097 gives £1,288,548. Principal of £10,000,000 at 0.793832 gives £7,938,322. The liability component is £9,226,871, and the equity component is the residual: £10,000,000 less £9,226,871, or £773,129.

At issue, debit cash £10,000,000, credit the financial liability £9,226,871 and credit equity £773,129.

Subsequent measurement is at amortised cost using the 8 per cent effective rate. Year one interest is £738,150 against a £500,000 coupon, taking the liability to £9,465,021. Year two interest is £757,202, taking it to £9,722,223. Year three interest is £777,777, taking it to exactly £10,000,000 at redemption. Total interest expense of £2,273,129 equals the £1,500,000 of coupons plus the £773,129 initial discount, which is the arithmetic check worth doing.

If the holders convert, debit the liability £10,000,000 and the equity conversion option £773,129, crediting share capital £500,000 and share premium £10,273,129. No gain or loss. If instead the bonds are redeemed in cash, the £773,129 stays within equity. It may be reclassified between reserves but it never reaches profit or loss.

One note for anyone using three-decimal exam tables: factors of 2.577 and 0.794 give a liability of £9,228,500 and equity of £771,500. That is a rounding difference, not an error.

If issue costs of £200,000 had been incurred, paragraph 38 allocates them in proportion to the allocation of proceeds: £184,537 against the liability, reducing its initial carrying amount and raising the effective rate above 8 per cent, and £15,463 deducted from equity.

Worked example: the preference share trap

Return to the opening. On 1 January 20X1 an entity issues 1,000,000 £1 preference shares at par, mandatorily redeemable at par on 31 December 20X5, with 6 per cent dividends payable at the entity discretion. The market rate for a similar instrument without the equity component is 8 per cent.

Because redemption is mandatory but the dividend is discretionary, the application guidance makes this a compound instrument. The liability is the present value of the redemption amount: £1,000,000 at 0.680583, or £680,583. Equity is the residual, £319,417. The liability accretes at 8 per cent — £54,447, £58,802, £63,507, £68,587 and £74,074 — reaching exactly £1,000,000 at redemption, and the total interest of £319,417 equals the equity component. Dividends actually paid are distributions from equity, not expense.

Now make the 6 per cent dividend contractual rather than discretionary. The entire £1,000,000 is a financial liability and the £60,000 annual dividend becomes interest expense in profit or loss. Paragraph 36 is explicit that dividend payments on shares wholly recognised as liabilities are recognised as expenses in the same way as interest on a bond.

Same legal instrument, same cash flows, and £60,000 a year moves between the income statement and the statement of changes in equity. That is the commercial consequence of getting classification wrong. The measurement mechanics on the liability side then follow IFRS 9.

One more trap in the other direction: redemption at the issuer option is not a liability, because the issuer has no present obligation. And where unpaid dividends are added to the redemption amount, the entire instrument is a liability.

Treasury shares, issue costs and offsetting

Paragraph 33 requires reacquired own equity instruments to be deducted from equity, with no gain or loss recognised in profit or loss on their purchase, sale, issue or cancellation, and consideration paid or received recognised directly in equity. Own equity is never a financial asset, regardless of the reason for which it was reacquired.

Paragraph 37 deals with issue costs: transaction costs of an equity transaction are accounted for as a deduction from equity to the extent they are incremental costs directly attributable to the equity transaction that otherwise would have been avoided. Costs of an abandoned equity transaction are expensed. Separating listing costs, which are expensed, from issue costs, which reduce equity, is a judgement the IFRIC has specifically flagged.

On offsetting, paragraph 42 permits a financial asset and financial liability to be offset when, and only when, the entity currently has a legally enforceable right to set off the recognised amounts and intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. Paragraph 46 adds that the existence of the right, by itself, is not a sufficient basis for offsetting. The cash pooling case is the practical illustration: a legally enforceable right plus regular but not period-end physical sweeps was not enough to demonstrate an intention to settle net. Netting an overdraft against a credit balance purely because the bank holds a right of set-off is the classic error.

What is changing, and the UK position

There are no amendments to IAS 32 effective in 2025 or 2026. The only pending change is consequential on IFRS 18, which amends paragraphs 34, 39 to 41 and part of the application guidance when IFRS 18 is applied, for periods beginning on or after 1 January 2027. Those are presentation cross-references only and change nothing about classification. Our guide to IFRS 18 covers the wider reform.

IAS 32 is a UK-adopted international accounting standard, and the UK Endorsement Board adopted IFRS 18 in December 2025, so the consequential amendments land in the UK on the same date.

The FRS 102 equivalent is Section 22, Liabilities and Equity, and it is broadly convergent: 22.3 reproduces the financial liability definition almost verbatim including both settlement limbs, and 22.13 applies the same residual method, determining the liability first and allocating the residual to equity, with 22.14 confirming the allocation is not revised in a subsequent period. Two real differences are worth knowing. FRS 102 allocates transaction costs between the components on the basis of their relative fair values rather than in proportion to the allocation of proceeds, which gives the same answer in ordinary cases but is differently worded. And 22.9 simply requires transaction costs of an equity transaction to be deducted from equity, without reproducing the incremental and directly attributable test or the rule that abandoned-transaction costs are expensed.