Key Points
- If the entity has a contractual obligation to deliver cash, it is a financial liability regardless of how management labels it.
- Classification drives measurement: amortised cost for most liabilities, fair value through profit or loss for those held for trading or designated.
- Inspectors flag hybrid instruments (convertible bonds, preference shares) where the liability and equity components were never separated.
- Getting the IAS 32 split wrong misstates both the balance sheet and finance costs for every period the instrument is outstanding.
What is Financial Liability?
IAS 32.11 defines a financial liability by what it obliges the entity to do, not by what the instrument is called. A bank loan is the obvious case. But redeemable preference shares, written put options over own equity, contingent consideration payable in a business combination, and the host component of a convertible bond all meet the definition too, because each creates a contractual obligation to deliver cash or exchange instruments on potentially unfavourable terms.
Measurement follows IFRS 9.4.2. On initial recognition the entity measures the liability at fair value (minus transaction costs if not designated at FVTPL). After that, most financial liabilities stay at amortised cost using the effective interest method. The exceptions are liabilities held for trading and any liability the entity irrevocably designates at fair value through profit or loss on initial recognition under IFRS 9.4.2.2.
The designation option exists for a reason. IFRS 9.4.2.2 permits it only when it eliminates or significantly reduces an accounting mismatch. That constraint is real. The entity cannot designate a vanilla bank loan at FVTPL simply because it prefers mark-to-market treatment.
Worked example: Ferrero Holding Italia S.p.A.
Client: Italian food producer, FY2024, revenue €185M, IFRS reporter.
Step 1 — Identify the instrument
Ferrero issues a €10M convertible bond maturing in five years, paying 2.5% annual interest, convertible into ordinary shares at the holder's option at maturity.
Step 2 — Split the components
The fair value of a comparable non-convertible bond (same credit rating, same term, 4.1% market rate) is €9.23M. That is the liability component on initial recognition. The residual €0.77M is the equity component.
Step 3 — Subsequent measurement
The liability component is measured at amortised cost. The effective interest rate is 4.1%, so Year 1 finance cost is €378K (€9.23M × 4.1%), not the €250K cash coupon. The difference of €128K accretes to the carrying amount.
Step 4 — Audit the classification
The engagement team verifies that management separated the compound instrument. If Ferrero had booked the full €10M as a liability, equity would be understated by €0.77M and finance costs would be wrong for every remaining period.
Conclusion: The liability component of €9.23M at initial recognition, measured subsequently at amortised cost with a 4.1% effective interest rate, is defensible because the split follows IAS 32.28 and the valuation inputs are documented with source data.
Why it matters in practice
The FRC's 2022 thematic review on financial instruments found that firms failed to separate compound instruments into liability and equity components. Files recorded the full nominal amount as a liability without performing the IAS 32.28 split. This overstated liabilities, understated equity, produced incorrect finance cost figures throughout the instrument's life, and misstated diluted earnings per share where applicable.
Teams routinely classify redeemable preference shares as equity because the shares carry the label "share capital." IAS 32.18(a) is explicit: if the issuer has a contractual obligation to redeem, the instrument is a financial liability. The legal form does not override the contractual substance.
Financial liability vs equity instrument
The distinction sits on one question: does the entity have a contractual obligation to deliver cash? IAS 32.16 draws the line. An ordinary share gives the holder a residual interest after all liabilities are settled. No obligation to deliver cash exists, so it is equity. A redeemable preference share obligates the entity to pay a fixed amount on a fixed date. That is a financial liability.
On an engagement, the practical difference affects the debt-to-equity ratio, covenant compliance, finance cost recognition, and the presentation of distributions (interest expense versus dividends). Misclassification in one direction flatters leverage ratios. Misclassification in the other inflates finance costs. Both produce material misstatements that compound over the instrument's life.