5.1 The Equity Technique, Different Perspectives 135The fundamental principle of IAS 32 is that a financial instrument should be
classified as either a financial liability or an equity instrument according to the
substance of the contract, not its legal form.^5 A financial instrument is an equity
instrument only if: (a) the instrument includes no contractual obligation to deliver
cash or another financial asset to another entity; and, (b) if the instrument will or
may be settled in the issuer’s own equity instruments, it is either: (1) a non-
derivative that includes no contractual obligation for the issuer to deliver a vari-
able number of its own equity instruments; or (2) a derivative that will be settled
only by the issuer exchanging a fixed amount of cash or another financial asset for
a fixed number of its own equity instruments.^6
According to IFRS, increases in equity result from: (a) the issue of equity in-
struments; (b) contributions from owners; (c) net profits; and (d) fair value ad-
justments that have a positive impact on equity. Decreases in equity result from:
(a) distributions to owners; (b) the repurchase of an entity’s shares; (c) net losses;
and (d) fair value adjustments that have a negative impact on equity.
Equity instruments include an entity’s issued shares, and options and warrants
held by external parties to purchase those shares.^7 Classification of financial in-
struments as financial liabilities or equity instruments is complex, and certain in-
struments may have the characteristics of both.^8 IFRS specifically define equity
instruments as any contract that evidences a residual interest in an entity’s assets
after deducting its liabilities.^9 An equity instrument, in contrast with a financial li-
ability, does not give rise to a contractual obligation on the issuer’s part to deliver
cash or another financial asset or to exchange another financial instrument under
conditions that are potentially unfavourable.^10
For example, where assets may never be distributed to shareholders or may be distributed
to shareholders only with the consent of the shareholders’ meeting, those assets can be re-
garded as equity capital, because there is no contractual obligation to make distributions.
Assets mentioned in § 57(1) AktG are therefore regarded as equity for the purposes of
IFRS.^11
The application of those principles can further be illustrated by preference shares and
shares in co-operatives. (1) Depending on the circumstances, preference shares can be re-
garded either as financial liabilities or as equity instruments. If an enterprise issues prefer-
ence shares that pay a fixed rate of dividend and that have a mandatory redemption feature
at a future date, the substance is that they are a contractual obligation to deliver cash and,
therefore, should be recognised as a liability. In contrast, normal preference shares do not
have a fixed maturity, and the issuer does not have a contractual obligation to make any
payment. Therefore, they are equity.^12 (2) Members’ shares in co-operative entities have
(^5) IAS 32.15.
(^6) IAS 32.16.
(^7) IAS 39R.2(e).
(^8) For compound instruments, see IAS 32R.28–32.
(^9) IAS 32R.11.
(^10) IAS 32R.15–18.
(^11) See Kraft ET, Die Abgrenzung von Eigen- und Fremdkapital nach IFRS, ZGR 2–3/2008
pp 331–332.
(^12) IAS 32.18.