6.1 Introduction 285sist of an equity component and a debt component in the balance sheet (hybrid
mezzanine). However, there is no mezzanine category according to IFRS. A mez-
zanine instrument is recognised as equity or as debt.
The categorisation on the balance sheet has an effect on the equity ratio and on
the recognition of the paid costs. If the mezzanine capital is recognised as debt,
any remuneration paid to holders of those mezzanine instruments will be an inter-
est expenditure. If the mezzanine capital is recognised as equity, any remuneration
will be a distribution of profits.
According to IAS/IFRS, the economic substance of the financial instrument is
the main factor to be taken into account (“substance over form”).^6 The fundamen-
tal 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 con-
tract, not its legal form (IAS 32.15).
A financial instrument is an equity instrument only if (a) the instrument in-
cludes no contractual obligation to deliver cash or another financial asset to an-
other entity, and (b) if the instrument will or may be settled in the issuer’s own
equity instruments, it is either: a non-derivative that includes no contractual obli-
gation for the issuer to deliver a variable number of its own equity instruments; or
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
(IAS 32.16).
There are particular rules on compound financial instruments. Some financial
instruments have both a liability and an equity component from the issuer’s per-
spective. According to IFRS, the component parts must be accounted for and pre-
sented separately according to their substance based on the definitions of liability
and equity (IAS 32.28). Convertible loans belong to this category.
Basel II. The recognition of an instrument as an equity capital instrument (Tier
1 capital), hybrid debt capital instrument (Tier 2 capital), or subordinated term
debt instrument (Tier 2 capital) can help a bank to increase its capital base for
regulatory purposes (see also section 5.1).^7 There can be Tier 3 capital in some ju-
risdictions. Tier 2 and Tier 3 capital instruments are mezzanine instruments.
Of the mezzanine instruments that can be recognised as capital, the recognition
of hybrid debt capital instruments as Tier 2 capital instruments is least problematic
according to the Basel Committee on Banking Supervision.
The Basel II Accord states: “In this category fall a number of capital instruments which
combine certain characteristics of equity and certain characteristics of debt. Each of these
has particular features which can be considered to affect its quality as capital. It has been
agreed that, where these instruments have close similarities to equity, in particular when
they are able to support losses on an on-going basis without triggering liquidation, they
(^6) The relevant regulations for the recognition of equity and debt capital and for receipt of
income from such capital are IAS 32 Financial Instruments: Disclosure and Presentation
(revised 2003) for treatment in companies/issuers of the financial instruments and IAS
39 Financial Instruments: Recognition and Measurement (revised 2003) for treatment at
the investor level.
(^7) Paragraph 49(iii) of the Basel II Accord.