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Financial Instruments Definitions and Classification under IAS 32

Updated 11 October 2026 · Fact-checked

A financial instrument is a contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another. Under IAS 32, classify the issuer's side by substance: if the issuer has a contractual obligation to pay cash or another financial asset, it is a liability. Otherwise it is equity.

Understand Financial Instruments Definitions and Classification

A financial instrument is any contract that creates a financial asset for one party and a financial liability or equity instrument for another. Think of a loan. The lender holds a receivable (an asset). The borrower owes cash (a liability). Both sides come from one contract.

A financial asset includes cash, an equity instrument of another entity (such as shares you hold in another company), and a contractual right to receive cash or another financial asset from another party (such as a trade receivable or a loan receivable). It also includes some contracts that will or may be settled in the entity's own shares.

A financial liability is a contractual obligation to deliver cash or another financial asset to another party. It also covers an obligation to exchange financial instruments on potentially unfavourable terms. An equity instrument is any contract that shows a residual interest in the assets of an entity after deducting all its liabilities. Ordinary shares are the standard example.

The key test is substance over legal form. IAS 32 asks whether the issuer can avoid paying out cash. If the issuer cannot avoid a payment, because the contract requires it, the instrument is a liability. If payment is entirely at the issuer's discretion, it is equity. A share that is legally called a share can therefore be a liability.

This matters for preference shares. Redeemable preference shares that must be redeemed on a fixed date, or that the holder can require the issuer to redeem, are liabilities. Their dividends are then treated as finance costs in profit or loss. Irredeemable preference shares with discretionary dividends are equity, and their dividends are shown in the statement of changes in equity. If dividends are mandatory but the shares are irredeemable, the obligation to pay dividends makes the instrument a liability. IFRS 9 then governs how these items are recognised and measured, which you study in later topics.

Key rules to remember

Financial instrument: Contract → financial asset of one entity AND financial liability or equity instrument of another; Physical assets, prepayments and most tax balances are not financial instruments because they do not arise from a contract to receive or pay cash or other financial assets.
Financial liability test: Contractual obligation to deliver cash or another financial asset (or exchange on potentially unfavourable terms) = liability; If the issuer cannot avoid payment, it is a liability, whatever the legal name.
Equity test: No contractual obligation to pay + residual interest in net assets = equity; Payment depends entirely on the issuer's discretion.
Preference share rule: Mandatory redemption or holder's right to redeem = liability; dividends = finance cost. Irredeemable with discretionary dividend = equity; dividends = distribution; Mandatory dividends on irredeemable shares also point to a liability.
Fixed-for-fixed rule: Settled by exchanging a fixed amount of cash for a fixed number of own shares = equity; A variable number of shares, or a variable amount of cash, usually points to a liability.

How to solve Financial Instruments Definitions and Classification questions

Use this method for any question asking you to classify an instrument or explain the treatment of a share or loan.

1Identify the issuer and the holder. Classification differs for each side of the contract.
2Check whether it is a financial instrument at all. Look for a contract giving a right to, or obligation for, cash or another financial asset.
3Ask whether the issuer has a contractual obligation to pay cash or another financial asset, either on redemption or as a required dividend or interest.
4Look for hidden obligations: redemption on a fixed date, holder's option to redeem, mandatory dividends, or settlement in a variable number of shares.
5If an obligation exists, classify as a financial liability and treat the payments as finance costs. If there is none, classify as equity and treat payments as distributions.
6State the reason using the words 'contractual obligation' and 'substance over form'. Markers look for this.
7Show the effect on the financial statements: where the item sits in the statement of financial position and where the payments go.

Quickest way: The Can They Avoid Paying? test

When to use it: Use this for objective test questions where you have about two to three minutes per mark-pair and must choose between liability and equity quickly.

Underline the words about redemption and dividends in the scenario.
Ask: can the issuer avoid paying cash completely? If no, it is a liability.
Redeemable on a fixed date or at the holder's option means liability.
Dividends at the directors' discretion and no redemption means equity.
Check the options for the matching finance cost or distribution treatment, then pick.

Common mistakes in Financial Instruments Definitions and Classification

Classifying all preference shares as equity because they are called shares.
Students follow the legal form instead of the substance.
Fix: Always check redemption terms and dividend obligations. Mandatory redemption makes it a liability.
Treating dividends on redeemable preference shares as a distribution in equity.
Students remember that dividends are distributions and forget the share has been classified as a liability.
Fix: If the share is a liability, its dividend is a finance cost in profit or loss.
Treating prepayments, inventory or deferred income as financial assets or liabilities.
Students see an amount owed or paid and assume it is a financial instrument.
Fix: A financial instrument needs a contractual right or obligation to cash or another financial asset. A prepayment is settled with goods or services, so it does not qualify.
Classifying from the holder's point of view instead of the issuer's.
Students confuse who holds the asset and who owes the liability.
Fix: Name the issuer first. The issuer classifies as liability or equity, and the holder classifies as an asset.
Assuming a shareholder's right to a discretionary dividend creates a liability.
Students treat any possible payment as an obligation.
Fix: A liability needs a contractual obligation. A dividend the issuer may decide not to pay creates no obligation.

Worked examples

Example 1

Delta Co issues 1 million ₹100 preference shares at par. The shares carry a 6% dividend that must be paid each year and are redeemable at par in five years. Classify the shares in Delta's financial statements and state the treatment of the dividend.

Show the solution

Delta is the issuer, so assess the contract from Delta's side.
The shares must be redeemed in five years. Delta cannot avoid paying cash, so there is a contractual obligation.
The dividend is also mandatory, which is a second obligation to pay cash.
Under IAS 32 the substance is a financial liability, not equity.
The annual dividend is 6% × ₹10,00,00,000 = ₹60,00,000. This is treated as a finance cost in profit or loss, not as a distribution.

Answer: The preference shares are a financial liability of ₹10,00,00,000 at issue. The ₹60,00,000 annual dividend is a finance cost in profit or loss.

Example 2

Eta Co has two instruments. Instrument 1: irredeemable preference shares where dividends are payable only if the directors declare them. Instrument 2: a ₹5,00,000 loan from a bank, repayable in three years. Classify each from Eta's point of view and give the treatment of payments.

Show the solution

Instrument 1: the shares are irredeemable, so there is no obligation to repay capital.
Dividends are at the directors' discretion, so Eta can avoid paying cash. There is no contractual obligation.
Instrument 1 is therefore an equity instrument. Any dividends are shown as distributions in the statement of changes in equity.
Instrument 2: Eta must repay ₹5,00,000 and pay interest under the contract, so it is a contractual obligation to deliver cash.
Instrument 2 is a financial liability. Interest is a finance cost in profit or loss.
From the bank's side, the loan is a financial asset.

Answer: Instrument 1 is equity, with dividends as distributions in equity. Instrument 2 is a financial liability, with interest as a finance cost. The bank holds a financial asset.

Exam tips

In objective test questions, scan for the words 'redeemable', 'mandatory', 'at the option of the holder' and 'discretionary'. They usually decide the answer.
In written answers, name IAS 32 and use the phrase 'contractual obligation to deliver cash'. Then apply it to the facts given.
Always finish with the double effect: classification in the statement of financial position and the matching finance cost or distribution.
Read who the question asks about. The same loan is a liability for the borrower and an asset for the lender.
Do not waste time on measurement here. If the question only asks for classification, state the category and the reason, then move on.

Practice questions from Financial instruments

Financial Instruments Definitions and Classification in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial Instruments Definitions and Classification: frequently asked questions

Are redeemable preference shares a liability or equity?

Redeemable preference shares are normally a financial liability because the issuer has a contractual obligation to repay on a fixed date, or the holder can demand redemption. Their dividends are treated as finance costs. Only shares with no redemption obligation and discretionary dividends are equity.

What is the difference between a financial asset and a financial liability?

They are two sides of one contract. The party with the right to receive cash or another financial asset holds a financial asset. The party with the obligation to pay holds a financial liability. A bank loan is an asset for the bank and a liability for the borrower.

Why does IAS 32 classify by substance and not legal form?

The legal name of an instrument can hide an obligation to pay cash. Classifying by substance shows users the true claims on the entity's resources. This stops companies presenting debt as equity to improve gearing.

Are trade receivables and payables financial instruments?

Yes. A trade receivable is a contractual right to receive cash, so it is a financial asset. A trade payable is a contractual obligation to pay cash, so it is a financial liability. Tax balances and prepayments are not, because they do not arise from contracts of this kind.