Solution

Such a contract is a financial liability of the entity even though the entity can settle it by delivering its own equity instruments. It is not an equity instrument because the entity uses a variable number of its own equity instruments as a means to settle the contract. The underlying thought behind this conclusion is that the entity is using its own equity instruments ‘as currency’.

Although the debentures are convertible into equity shares of CBA Limited, the fact that the conversion is based on a pre-determined formula that uses the fair value of the shares on the date of conversion means that the number of equity shares to be issued is not fixed at the time of issuance. As such, the entity is using its own equity shares as a means of settling the contract, and therefore the debentures will be classified as a financial liability.