IAS 32 Financial Instruments: Classification, Offsetting, and FICE

Under IAS 32, an issuer of a financial instrument must classify it as a financial liability or as equity based on the substance of the contract, not its legal form. A contract that obliges the entity to deliver cash or another financial asset is a liability; a contract that represents a residual interest in the entity’s net assets is equity. The standard also governs how compound instruments are split, how treasury shares and related payments are reported, and when a financial asset and a financial liability may be offset on the balance sheet. IAS 32 sits alongside IFRS 9, which handles recognition and measurement, and IFRS 7, which handles disclosure.

Liability or Equity: The Core Classification Test

A financial liability arises whenever the issuer has a contractual obligation to deliver cash or another financial asset to another party.¹ If the entity has no unconditional right to avoid that delivery, the instrument is a liability whatever it is called. A security labeled “preferred equity” that must be redeemed for cash on a set date is debt for IAS 32 purposes.

An equity instrument is a contract evidencing a residual interest in the entity’s assets after deducting all liabilities. For an instrument settled in the entity’s own shares to qualify as equity, it must satisfy the fixed-for-fixed condition: the issuer exchanges a fixed amount of cash (or another financial asset) for a fixed number of its own shares, with no variability on either side. A contract that requires the issuer to deliver whatever number of shares equals a specified cash amount is a liability, because the shares are being used as currency to settle a monetary obligation.²

A narrow exception preserves equity treatment for rights issues. When an entity offers rights, options, or warrants to acquire a fixed number of its own shares for a fixed amount in any currency, the instruments are equity provided they are offered pro rata to all existing holders of the same class of non-derivative equity.³

Settlement Choices

When a derivative gives one party the choice of settlement method, the instrument is a financial liability unless every possible settlement outcome would independently qualify as equity. A share option the issuer can settle either by delivering shares or by paying cash is a liability, because the cash alternative alone creates a potential obligation to deliver cash.³ The presence of a share-based path does not rescue the classification. IAS 32 looks to the worst-case settlement route.

Contingent Settlement Provisions

Some contracts require cash settlement only if a specified uncertain event occurs, such as a change in an index, interest rate, tax law, or the issuer’s own debt-to-equity ratio. If that triggering event lies beyond the control of both issuer and holder, the instrument is a financial liability, because the issuer cannot unconditionally avoid the payment.³ Three carve-outs exist: the contingent provision is not genuine (the trigger is extremely unlikely), cash settlement can only be required on the issuer’s liquidation, or the instrument satisfies the puttable-instrument criteria.

The Puttable Instruments Exception

IAS 32 allows certain instruments containing an obligation to deliver cash to be classified as equity anyway. The exception exists chiefly for partnerships and similar entities whose ownership interests are all puttable by nature; without it, they would report no equity at all.

A puttable instrument qualifies as equity only if it meets every one of the following:

The holder is entitled to a pro rata share of the entity’s net assets on liquidation.
The instrument sits in the most subordinate class, with no priority over other claims.
All instruments in that subordinate class have identical features, including the same redemption formula.
Aside from the repurchase obligation itself, the instrument imposes no other requirement to deliver cash or to exchange financial instruments on unfavorable terms.
Total expected cash flows over the instrument’s life depend substantially on profit or loss, changes in recognized net assets, or changes in the fair value of net assets.

The entity must also hold no other instrument or contract that would substantially fix or restrict the residual return to holders of the puttable instrument.³ A parallel set of criteria covers instruments that obligate the entity to deliver a pro rata share of net assets only on liquidation. If an instrument later stops meeting the criteria, it is reclassified to a financial liability at fair value, with any difference recognized directly in equity.

Compound Instruments: Splitting Debt and Equity

Some instruments carry both liability and equity features. A convertible bond is the classic case: the issuer receives cash, promises interest and principal, and grants the holder the right to convert into a fixed number of shares instead of taking cash at maturity. IAS 32 requires the issuer to separate the components and present each in its own category.³

The split runs in one direction only. The issuer first measures the fair value of a comparable bond without the conversion feature; that amount is the liability component. Whatever remains of the total proceeds is assigned to equity as a residual. The equity component is never measured directly at fair value. Initial classification is not revisited even if conversion later looks likely, and transaction costs are split between the two components in proportion to the allocation of proceeds.³

Where Interest, Dividends, and Gains Are Reported

Classification controls where the associated cash flows land. Interest, dividends, losses, and gains on an instrument classified as a financial liability are recognized in profit or loss. Dividends on shares that are wholly classified as liabilities are treated as an expense in the same way as interest on a bond.³

Distributions to holders of equity instruments are recognized directly in equity and never touch profit or loss. The same payment on the same preferred share can therefore either reduce reported profit or move only within equity, depending purely on how the instrument is classified. Income tax effects of distributions to equity holders follow IAS 12.

Treasury Shares

When an entity reacquires its own shares, those treasury shares are deducted from equity. An entity cannot hold a financial asset in itself, so the reacquired instruments are never recognized as an asset.¹

No gain or loss is recognized on the purchase, sale, issue, or cancellation of an entity’s own shares. Cash paid to repurchase reduces equity, cash received on reissue increases equity, and cancellation simply adjusts equity to reflect the reduced share count. Profit or loss is not affected at any stage, which prevents entities from generating reported earnings by trading in their own stock.³

Offsetting a Financial Asset and a Financial Liability

Financial assets and liabilities are ordinarily presented gross. IAS 32 permits presenting them net only where both of the following conditions are met at the same time:

The entity currently has a legally enforceable right to set off the recognized amounts. The right must not depend on any future event, and it must be enforceable in the normal course of business, on default, and on the insolvency or bankruptcy of the entity and every counterparty.
The entity intends either to settle on a net basis or to realize the asset and settle the liability simultaneously.

Meeting only one condition is not enough.³

Master Netting Arrangements

Master netting agreements do not, on their own, justify offsetting. They typically create a right of set-off that becomes enforceable only on default or another extraordinary event, not in ordinary operations. Because IAS 32 requires the right to be currently enforceable in all circumstances, most master netting arrangements fail the test.⁴ Amounts covered by such agreements are reported gross unless each specific pair of assets and liabilities separately satisfies both offsetting conditions.

What IAS 32 Does Not Cover

Several categories of instruments sit outside IAS 32 because other standards govern them. Interests in subsidiaries, associates, and joint ventures follow IFRS 10, IAS 27, or IAS 28, though IAS 32 still applies to derivatives over those interests. Employee benefit obligations fall under IAS 19. Insurance contracts within IFRS 17 are excluded, though IAS 32 still reaches separated embedded derivatives and investment components accounted for under IFRS 9. Share-based payment arrangements follow IFRS 2, except that IAS 32’s treasury share rules still apply when shares are bought or sold in connection with them.⁵

Pending FICE Amendments

The IASB has been developing amendments to IAS 32 through its Financial Instruments with Characteristics of Equity project, aimed at refining the classification rules, particularly around the fixed-for-fixed condition and contingent settlement provisions. As of early 2026, the IASB is redeliberating feedback on its exposure draft and has not yet issued final amendments.⁶ Any final changes could shift the classification of instruments that currently sit near the debt-equity boundary, and preparers holding such instruments should track the project.

1
IFRS Foundation. IAS 32 Financial Instruments: Presentation – Section: Definitions
2
IFRS Foundation. IASB Staff Paper – Financial Instruments with Characteristics of Equity (FICE)
3
IFRS Foundation. IAS 32 Financial Instruments: Presentation
4
IFRS Foundation. IAS 32 Financial Instruments: Presentation
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IFRS Foundation. International Accounting Standard 32 Financial Instruments: Presentation
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IFRS Foundation. Financial Instruments with Characteristics of Equity