(b) Advise Kutchen on the difference between equity and liabilities, and on the proposed accounting treatment of the contingent payments on the subsequent acquisition of 20% of Mach. (8 marks)

Answer for (b)   amended by Keryn

The Framework defines a liability as a present obligation, arising from past events with a potential of future economic benefits outflow. IAS 32 Financial Instruments: Presentation establishes principles for presenting financial instruments as liabilities or equity. IAS 32 does not classify a financial instrument as equity or financial liability on the basis of its legal form but on the substance of the transaction. The key feature of a financial liability is that the issuer is obliged to deliver either cash or another financial asset to the holder. An obligation may arise from a requirement to repay principal or interest or dividends.

In contrast, equity has a residual interest in the entity’s assets after deducting all of its liabilities. An equity instrument includes no obligation to deliver cash or another financial asset to another entity. A contract which will be settled by the entity receiving or delivering a fixed number of its own equity instruments in exchange for a fixed amount of cash or another financial asset is an equity instrument. However, if there is any variability in the amount of cash or own equity instruments which will be delivered or received, then such a contract is a financial liability as applicable.

In accordance with IFRS 3 Business Combinations, contingent consideration for a business must be recognised at the time of acquisition and measured at its fair value. The contract for contingent payments does meet the definition of a financial liability under IAS 32. Kutchen has an obligation to pay cash to the vendor of the NCI under the terms of a contract. The amount of the contingent payments depends on the profitability of Mac which means this is not within Kutchen’s control to be able to avoid that obligation. According to IAS 32, it meets the definition of a financial liability.

Since the contingent payments relate to the acquisition of the NCI, the offsetting entry would be recognised directly in equity.