Discussion at the June 2004 IASB Meeting
The Board discussed creating an exception to the liability classification for shares that evidence a residual interest in the assets of an entity and that are puttable to the entity at fair value. It was noted that IAS 32 currently requires classifying these instruments as liabilities. If the fair value exceeds the recorded net asset value, this results in a recorded net liability position.
The Board expressed mixed views. Some were concerned about reporting a net liability position, and they favoured an immediate solution. Others believe that the issue is more fundamental because it relates to the definitions of equity and liabilities; they want to wait for that project to be finalised. The Board asked the staff to explore the issue further and consider whether a short-term solution that can be restricted to solving the immediate problem is apparent.
Discussion at the July 2004 IASB Meeting
At its June meeting, the Board had a preliminary discussion on the classification as liabilities or equity of financial instruments puttable at a pro rata share of the fair value of the residual interest in the issuer ('financial instruments puttable at fair value'). The Board noted that the application of IAS 32 to financial instruments puttable at fair value gives rise to anomalous accounting because, assuming that the fair value of the entity is higher than the entity's net asset value, the balance sheet will always show net liabilities, and those net liabilities will increase the better the entity performs.
The Board agreed to explore whether it should propose an amendment to IAS 32 in the short term through one of the following possible approaches:
(a) An exception so that instruments puttable at fair value are classified as equity;
(b) Continuing to classify such instruments as liabilities but amending their
measurement so that changes in their fair value would not be recognised;
(c) Considering whether all puttable instruments (and not only those puttable at
fair value) should be separated into a put option and a host instrument.
(d) Do nothing (staff recommendation).
Concerns were raised regarding amendments to IAS 32 at this stage, but if an amendment were to be made, the Board leaned toward approach (a).
Approach (a)
If the Board decides to use approach (a), the staff proposed the following drafting:
A financial instrument that will or may require the entity to redeem it and that otherwise evidences a residual interest in the assets of an entity after deducting all of its liabilities shall be classified as a liability unless all of the following criteria are met:
- there is no other instrument classified as equity.
- the instrument is the most subordinated class of all instruments issued by the issuer and has no preferential rights relative to other instruments of the issuer.
- the redemption price is a pro-rata share of the fair value (or, in the absence of an otherwise determinable fair value, a formula that all the shareholders agree represents a reasonably close approximation of fair value) of the residual interest in the assets of the issuer at the redemption date.
- the redemption event is the same for all of the instruments.
- holders of the instrument participate in the issuer's net assets and distributions of profit on a prorate basis."
More detailed guidance would be provided in the Application Guidance. It was also suggested that an additional restriction be added making it clear that this exception would only be available to non-public entities.
Approach (b)
If the Board decides to use approach (b), the staff recommends that the Board:
- introduce a fifth category of financial instruments in the definitions (eg 'financial liabilities that evidence a residual interest in the entity'. Such a category would be defined along the lines of the exception proposed in approach (a);
- amend paragraph 47 of IAS 39 to specify that financial liabilities in this fifth category are measured at the amount initially recognised and not re-measured, as follows:
"After initial recognition, an entity shall measure all financial liabilities at amortised cost using the effective interest method, except for:
(c) financial liabilities that evidence a residual interest in the entity, which shall be not be re-measured subsequent to initial recognition."
Staff were asked to continue work on approach (a) by considering as many examples as possible that would then be discussed at the September meeting, so the Board can assess the extent of the impact of such an amendment.
Discussion at the March 2005 IASB Meeting
Background
The Board considered the issue of financial instruments that are puttable at a pro rata share of the fair value of the residual interest in the issuer. An example would be an open ended mutual fund, which gives unit holders the right to redeem their interests in the enterprise at any time for an amount of cash equal to their proportionate share of the net asset value of the entity.
The Board noted that financial instruments puttable at fair value are classified as liabilities under IAS 32, but this gives rise to strange accounting whereby the fair value of the entity differs from the reported carrying amount of the entity's net assets, for example, because of unrecognised assets (such as goodwill) and the measurement of some assets at cost.
At its July 2004 meeting, the Board rejected two possible solutions to this issue. The rejected options were:
- to continue to classify these instruments as liabilities but amend their measurement so that changes in their fair value would not be recognised; and
- to separate all puttable instruments into a put option and a host instrument.
The proposal
The Board's proposed solution is an amendment to IAS 32 to classify puttable instruments at fair value as equity. The proposed amendment will allow the entity to have other instruments classified as equity so long as the instruments rank above the puttable instruments and do not have an interest in the residual net assets of the issuer.
A board member pointed out that this solution would mean, for example, that 10-year bonds puttable at fair value are classified as equity, which is not really an acceptable answer. Whether the words of the proposal actually implied this, however, was debatable according to other board members.
Treatment of mandatorily redeemable instruments was considered due to feedback indicating that there is some confusion over whether 'puttable instruments' include puttable instruments with a fixed term.
IAS 32.18(b) suggests that a 'puttable instrument' does not include an instrument mandatorily redeemable on a fixed date. This contrasts with IAS 32.BC7, which argues that it makes no difference whether an instrument is puttable on only one date or on a variety of dates for deciding its classification as a financial liability. The latter view is the basis of the proposal.
As per the proposal, there are many examples of fixed period activities where the equity holders are sharing the residual risk of the activity. In the present case, allowing for a fixed date redemption should not increase the risk of financial engineering because the redemption event must be the same for all of the instruments.
Therefore the proposal suggested a consequential amendment to the definition of 'puttable instruments' in IAS 32.18(b) to clarify that the term 'puttable instrument' includes puttable instruments that have a fixed term such as mandatorily redeemable with a fixed term.
The Board accepted the need for guidance but raised several points for consideration:
- An entity could potentially end in a negative equity position if it has puttable options on equity also classified as such.
- The proposal was too rules-based, and could, therefore still lead to financial engineering.
- The FASB and the IASB are currently working on a project which considered classification between debt and equity issues. This proposal is not consistent with FASB's thinking so far.
- Perhaps the amendment should wait until the debt vs. equity project is finalised, or should be included in that project rather than considered separately.
- Why should only the lowest ranking classes apply the options? What if they were all similar, except for the redemption feature? There is no guidance in the proposal on which rank higher.
Staff were instructed to extend the scope to consider:
- Puttable minority interests.
- Partnership entities.
- Limited life entities.
- Different classes of shares.
Also, staff should consider the FASB project on debt vs equity.
Discussion at the IASB's September 2005 Meeting
Scope of the project
At its March 2005 meeting, the Board agreed to give further consideration to accounting for financial instruments puttable at a pro rata share of the fair value of the residual interest in the issuer ('financial instruments puttable at fair value'). As IAS 32 currently stands, these instruments are classified as financial liabilities. The Board noted that the application of IAS 32 and IAS 39 to financial instruments puttable at fair value, when those shares are the common shares of the entity, gives rise to anomalous accounting.
As a result of the Board's decisions in March 2005, the staff recommended two categories of amendments to IAS 32:
- 1. The first category encompasses the definition and classification of a 'financial instrument puttable at fair value' and is aimed at shares, partnership interests, and minority interest puttable at fair value. Those classes of instruments have similar features, giving the holder the right to put the instrument back to the entity in exchange for its fair value, which is the instrument's pro rata share of the fair value of the issuer.
- 2. The second category addresses instruments that have an obligation arising on liquidation. Instruments in limited life entities do not normally contain the right to put the instrument back to the issuer during the life of the entity. Instead, such instruments confer the right to receive cash or other assets on liquidation of the entity, with liquidation being a certain event. Put another way, shares in limited life entities establish an obligation that arises on liquidation, and liquidation will occur at a known date.
The amendments would result in all of the following being classified and presented as equity: shares, partnership interests, and minority interests puttable at fair value, and shares in limited life entities.
For discussion purposes, the issues were analysed as follows:
- 1. Instruments puttable at fair value.
- 2. Instruments with obligations arising on liquidation, and liquidation is certain (affects limited life entities).
- 3. Instruments with obligations arising on liquidation, and liquidation is at the option of the holder (affects partnership interests).
- 4. Classification of minority interests in consolidated financial statements, when minority interests are puttable at fair value or an obligation arises on liquidation (and liquidation is certain or at the option of the holder).
The Board decided to tackle issue 1 first, to set the guidelines from which the more complex issues down the list could be addressed. The Board discussed the staff's proposals at length, noting that whether the put option is a separate instrument from the shares should not result in different accounting. If this is not achieved, the result would be the creation of structuring opportunities.
The Board agreed that the only short-term solution to this issue would be to create exceptions until the long-term project dealing with equity and liabilities has been completed. This exception would specify that it would only be available for all of the equity that is the subject of the put option (that is, there would be no opportunity for other types of contracts to be written over similar equity instruments). In addition, that class of equity must be the 'absolute residual' the 'most subordinated' class of equity. Additional work would be performed to adequately ring-fence these exceptions.
The Board discussed what would constitute different classes of equity (for example, where different voting or participation rights attach to the same category of shares) but did not make decisions on this issue. The Board seemed to agree that in the consolidated financial statements, a non-controlling interest (minority interest) would be considered to be the same class of equity to that of the parent entity (that is, the existence of a non-controlling interest would not disqualify an entity from applying the exception).
Items 2 through 4 above were not addressed as distinct issues but were referred to at various points throughout the Board's discussions.
The Board noted the reservations of some members about the additional complexity that would be introduced into the accounting for financial instruments if these proposals are adopted. The Board agreed to proceed with this project, as it has already been taken onto the agenda and because the issue is significant.
Determining whether a share puttable at the fair value of the residual interest in the entity should be split into an ordinary share and a put option with approximately zero value
On this issue, the staff recommended the following:
A compound financial instrument should be split into components when it is clear that the components exist, that the components can be separated and when separating the components results in faithful representation of the financial position of the entity. In the case of the put option in a puttable share, the staff found that it was not possible to separate a component as it was not possible to economically identify those situations in which the put option would be exercised. In addition the put option component is not identifiable based on separate cash flows.
The staff also found that shares puttable at a fixed strike price are economically similar to convertible debt. Consequently the staff believes that classifying a puttable share as equity while classifying convertible debt principally as liability does not result in the faithful representation of what are economically similar obligations. In other words, the put option changes the nature but not necessarily the value of the obligation to shareholders.
Consequently, the staff did not recommend that a puttable share be split into an ordinary share and put option with a floating strike price.
Some Board members indicated support for the staff recommendation and others for an alternative approach that acknowledges that IAS 32's classification scheme is 'fundamentally flawed'. Supporters of the alternatives conclude that the composite instrument described as a puttable share does not satisfy the definition of a liability, and presenting it as a liability does not enhance the relevance of the financial statements. Proponents of this view acknowledge that there is a liability component of the instrument, but measuring that liability based on redemption amount described in IAS 32 is not the fair value of that component on initial recognition. Such measurement is inconsistent with how virtually all other financial instruments and most non-financial liabilities are measured (excepting, perhaps, employee benefit obligations).
The Board was asked to vote on whether (a) to continue a separate project on financial instruments puttable at fair value or (b) to address the issue in the broader and longer-term liabilities and equity project. The Board agreed to add this issue to the broader liabilities and equity project whilst continuing with the separate project on financial instruments puttable at fair value.
Discussion at the December 2005 IASB Meeting
The Board was asked to confirm proposed amendments to IAS 32, as a correct reflection of the Board's decisions at its September 2005 meeting (the proposals are set out in the observer notes).
The Board debated how best to narrow the amendment so as to ensure that the return over a period of time is the same for all instrument holders within the most subordinated class. The concern raised by some Board members related to the fact that the entry price of acquiring the instrument could be manipulated by adding premiums or discounts that could distort the return to individual holders. The staff was asked to add a condition to this effect along the lines of requiring entry and exit from the most subordinated class of equity at fair value.
In order to apply the proposed amendments, the staff noted that an entity must determine fair value in accordance with the IAS 39 application guidance. Partnerships or non-public companies, which calculate the fair value of the redemption price of the puttable instruments using a proxy measure (for example, book values or a pre-set formula based on book values), might not be able to apply the proposed amendments. This is because such proxy measures might not be consistent with the measurement of fair value under IAS 39, paragraphs AG69 to AG82. The Board agreed to allow the use of the proposed amendment in the above instances only where the share is not listed and the formula or proxy measure is an approximation of fair value.
The Board reiterated that the objective here is to reach fair value at entry and exit and that a formula designed to penalise early exit may not qualify as a fair value proxy.
The Board asked the staff to consider supplementary disclosures (as well as presentation issues) regarding the fair values of instruments captured by these amendments even though they are classified as equity. The rationale for supplementary disclosure requirements being that such instruments have potential claims on assets.
Limited life entities
The Board agreed to include within the proposed amendments to IAS 32, the issue of classification of instruments puttable at fair value in limited life entities. The Board also agreed to include a table of examples in the guidance clarifying that for limited life entities, the instruments are not puttable.
Liquidation at the option of the holder
The proposed amendments would allow equity classification of instruments that contain an obligation entitling the holder to a pro rata share of the net assets of the entity upon liquidation of the entity, including instruments that give the holder the option to require the entity to liquidate. Therefore, partnership interests that include a condition that requires the partnership to liquidate upon the exit of any partner will be classified as equity, if it has the required characteristics.
The Board discussed whether the requirements to liquidate upon the withdrawal of a partner are substantive. The concern was raised because in practice, the effect of a partner withdrawing would result in mere book entries.
The Board also registered concerns about extending the requirements to any instrument that allows the holder the ability to liquidate if that holder feels aggrieved in any way. The Board seemed to agree that the answer to this issue was to require that all the parties should have the same ability to require liquidation, therefore in the case of a partnership, every partner must be able to put to the partnership, his/her interest.
Consolidated financial statements
The Board considered the consequences of its decisions for consolidated financial statements. The Board agreed that the non-controlling interests must be regarded as being not in the most subordinated class of instruments from the group's perspective. The rationale for this view is that the claims of non-controlling interests to the net assets of the subsidiary have to be satisfied first, before the parent's share of the net assets of the subsidiary could be distributed to the parent's residual interest holders. Hence, non-controlling interests are not in the most subordinated class of instruments at the group level.
For limited life entities, the Board agreed that at the group level, non-controlling interests in a limited life subsidiary will be classified as financial liabilities. This is because the proposed amendments are based on the view that non-controlling interests are not in the most subordinated class of instruments at the group level. The Board also came to a similar view on the issue of obligations arising on liquidation when liquidation is at the option of the holder.
In considering the entire package of proposed amendments, the Board agreed by vote to proceed with the amendments with some Board members dissenting on the basis that these amendments were merely an exception to the principles of IAS 32 designed to address the specific concerns of certain constituents and as a consequence, sets a bad precedent.
Discussion at the February 2006 IASB Meeting
The Board continued its discussion from December 2005 on the proposed amendments to IAS 32 Financial Instruments: Presentation. At the previous meeting the Board decided that financial instruments puttable at fair value and certain obligations arising on liquidation would be classified as equity if certain conditions were met. Under those conditions, in general, shares, partnership interests, and minority interests puttable at fair value, and shares in limited life entities, would generally be classified as equity. At the February meeting the Board was asked to decide on proposed disclosures.
The staff proposed that four categories of new disclosures be added to IAS 1 and not IFRS 7. The Board agreed to the proposal.
The four proposed categories of new disclosures, and Board decisions on each, are as follows:
Disclosure by limited-life entities
As IAS 1 does not currently require limited-life entities to disclose the fact that they have a limited life, the staff proposed adding an explicit requirement by amending paragraph 126 of IAS 1.
The Board agreed.
Disclosure of reclassifications
The staff proposed that disclosures about the nature, amount, and timing of reclassifications of instruments between liabilities and equity, and the reasons therefor, be added to IAS 1.
No discussion. The Board agreed with the staff proposal.
Capital Disclosures
Staff proposed certain amendments to the capital disclosure requirements in paragraph 124 of IAS 1 so that an entity will disclose enough information about financial instruments puttable at fair value to enable users of financial statements to evaluate the entity's objectives, policies, and processes for managing capital.
The Board generally agreed with the staff proposal, though they asked the staff to do some additional research regarding one of the proposed disclosure items.
Disclosures about fair values
Staff proposed:
- disclosures about an instrument's fair value disclosures should be presented in a way that permits comparison with the instrument's carrying amount;
- disclosure of information on how fair value was determined; and
- additional disclosure items for companies who determine fair value based on a formula.
The Board discussed the cost of compliance against the benefits of the user if requirement was set out as in the proposals.
The Board decided to require the disclosures proposed by the staff, but that those disclosures would be required only in an entity's annual accounts, not in its interim accounts.
Discussion at the March 2006 IASB Meeting
The Board continued its discussion of a draft ED of proposed amendments to IAS 32 Financial Instruments: Presentation.
New project title
Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation
Sweep issues arising from the pre-ballot draft
A formula to determine fair value of financial instruments puttable at fair value by an entity that is not publicly accountable
The Board had previously allowed use of a formula to estimate fair value of financial instruments puttable at fair value upon issuance, redemption or repurchase of the instruments, provided that the formula is intended to approximate fair value. A national standard-setter had requested clarification about whether an instrument's pro rata share of the entity at book value qualifies as a formula.
The Board agreed that an amendment setting out that using the pro rata share of net assets of the entity at book value is not considered to be a formula that approximates fair value, except in rare cases when there is no material difference.
Appropriate guidance for determining fair value
A national standard-setter had requested that the exception in subparagraph 46(c) of IAS 39 be included in reference to guidance on determining fair value in the proposed amendments to IAS 32. This would imply that non-public entities would be allowed to redeem or repurchase puttable instruments at the instrument's cost and to classify these as equity.
The Board agreed that such a reference as the sub paragraph is only relevant for the measurement of the equity instruments of other entities, and not for when an entity measures its own equity instruments.
The issue price of an ordinary share puttable at fair value issued upon conversion of a convertible bond
The staff had been asked to consider whether the price of an ordinary share puttable at fair value issued upon conversion of a convertible debt instrument is considered to be at fair value. If not, the shares will not qualify for equity classification.
The staff identified two issues. The first issue was that this scenario would create an option embedded in the convertible bond that would have to be separated and accounted for as a derivative that meets the definition of a financial liability. The second issue the staff identified was that financial instruments puttable at fair value would only be considered issued at fair value if the fair value of the consideration received equals the fair value of the instruments issued (and thereby be qualified for equity classification).
The Board decided that the staff should draft application guidance for this issue.
Analysis of benefits and costs
The Board decided that they would consider this analysis at a later meeting.
Transition and effective date
The Board decided: on three staff proposals:
- The ED should not specify a proposed effective date. This issue will be left open for the moment.
- Early adoption will be permitted.
- The amendments will be applied retrospectively for both first time adopters as well as current users of IFRS.
- The Board agreed to provide an exemption from applying the requirement of IAS 32 retrospectively for compound financial instruments. Because the proposal was to apply the amendments retrospectively, a compound instrument with an obligation for a pro rata share of net assets arising on liquidation would have to be separated into a liability and an equity component from the instrument's inception (ref to point c) under sweep issues). At the date of application it could be that the liability component (the derivative) no longer is outstanding, that is, separation would have no benefit. This is the exact same reason there already is an exemption for applying the requirements in IAS 32 retrospectively for compound financial instruments under IFRS 1.
Discussion at the April 2006 IASB Meeting
This was a continuation of the discussion the Board had in its March meeting on proposed amendments to IAS 32, whereby financial instruments puttable at fair value and certain obligations arising on liquidation would be classified as equity, provided certain conditions are met. This discussion focussed on a staff analysis of the costs and benefits of the proposed amendments.
The staff analysis was that the main costs associated with the proposed amendments include:
- requiring a new analysis of various financial instruments;
- an increase in the complexity of IAS 32;
- an increase in financial structuring opportunities; and
- the costs of complying with the equity classification.
The staff analysis was that the main benefits associated with the proposed amendments include;
- it addresses constituents' concerns about the classification of certain financial instruments;
- it increases comparability between entities (for example between entities with financial instruments puttable at fair value that meet the requirements for equity classification and entities with ordinary shares); and
- the classification is more relevant and more understandable.
The Board noted that whilst they liked the proposed accounting for financial instruments puttable at fair value, they did not believe that the proposed amendments were principle-based, and that the main benefit was that the classification was more relevant and understandable to users. They further noted that care would be needed in describing comparability as a benefit, as financial instruments puttable at fair value are different from ordinary equity shares in that they allow the holder to require redemption for a cash amount. Furthermore, the equity classification is only available to the most subordinated class of instrument. As such, very similar instruments may get a different classification where one is the most subordinated class of instrument and the other is not.
The Board then discussed the proposed amendments to IAS 1. These changes require three new disclosures, as follows:
- 1. disclose information about the reclassification of instruments between equity and financial liabilities of the instruments affected by the amendments;
- 2. disclose fair values of financial instruments puttable at fair value classified as equity; and
- 3. disclose information about length of the life of a limited life entity.
As no new issues were raised, this should be the final discussion by the Board on this matter prior to issuance of an exposure draft.
June 2006: IASB ED on Puttable Shares
On 22 June 2006, the IASB published an exposure draft on Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation. The proposals would amend IAS 32 Financial Instruments: Presentation and IAS 1 Presentation of Financial Statements. The ED would require:
- An obligation to redeem or repurchase a financial instrument puttable at fair value would be classified as equity provided that specified criteria are met, particularly that all financial instruments in the most subordinated class of instruments with a claim to the assets of the entity are financial instruments puttable at fair value.
- An instrument that imposes an obligation to deliver to another entity a pro rata share of the net assets of the entity upon its liquidation to be classified as equity, provided specified criteria are met. Thus, for example, ordinary shares of limited life entities and partners' interests in a partnership that must liquidate upon exit of a partner (eg on retirement or death) would be equity.
Comments are due by 23 October 2006. The ED is available on the IASB's website. Click for Press Release (PDF 67k).
Discussion at the September 2006 IASB Meeting
The Board discussed various issues related to the operation of derecognition principles in IAS 39 paragraphs 15-37 and illustrated in IAS 39 AG36.
Groups of assets
The Board discussed the possible meanings of the phrase 'group of similar assets' contained in IAS 39 paragraph 16.
The Board agreed that IAS 39 does requires the derecognition tests to be applied to transfers of groups of financial assets (such as loans, mortgages, etc) that include the following derivative contracts:
- Credit insurance contracts/financial guarantees that are originated with certain loans.
- Interest rate swaps and currency swaps.
- Credit insurance contracts/financial guarantees that are not originated with the loans
In particular, the Board noted that because a bundle of assets (such as mortgage loans and mortgage indemnity guarantees) was transferred in a single transaction does not imply that the bundle was 'one asset'. In other words, the transferor had to assess the mortgage loans and the mortgage indemnity guarantees separately for the purposes assessing 'similar' in the derecognition tests.
Board members noted that the IFRIC might be uncomfortable with the consequence of this conclusion: that a derivative that can be either an asset or a liability must pass both derecognition tests before it can be removed from the balance sheet.
Pass-through arrangements
The Board which transfers of financial assets are required to satisfy the 'pass through' tests in IAS 39 paragraph 19. The Board noted that IAS 39 paragraph 18(b) states the pass-through tests in paragraph 19 have to be met when an entity transfers a financial asset and 'retains the contractual rights to receive cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients'. Conversely, the pass-through tests are not applicable when the entity 'transfers the contractual rights to receive the cash flows of the financial asset' (paragraph 18 (a)).
The Board agreed that IAS 39 did not require the pass-through test to be applied to transfers of financial assets in which (a) the legal ownership has not changed; and (b) the transfer is conditional.
Report to IFRIC
The Board noted that the topics discussed in this session had been referred to the IFRIC and asked the staff to make a complete report to the IFRIC, together with the Board's basis (essentially the Board papers), so that the IFRIC could make an informed decision as to how to proceed.
Discussion at the December 2006 IASB Meeting
Hedging of portions of cash flow or fair value exposure
The Board previously concluded that additional guidance is required regarding what can be designated as a hedged portion under IAS 39. IAS 39 permits an entity to hedge all cash flows of a financial instrument for one or more specific risks, but does not specify what risks are eligible for hedge accounting. The Board therefore addressed two issues at the December meeting:
- The first issue was whether IAS 39 should be amended to specify risks that are eligible to be designated for hedge accounting.
- The second issue was, since IAS 39 permits 'other portions' of the future cash flows on a financial instrument for its whole life or part of its time period to maturity to be designated as a hedged item, should the Board amend IAS 39 to clarify which specific 'other portions' of a financial instrument that are eligible for designation as a hedged item.
On the first issue the Board decided that IAS 39 should be amended to specify those risks which are eligible for designation as a hedged item.
On the second issue the Board voted and agreed to specify which 'other portions' of a financial instrument that would be permitted for designation as a hedged portion under IAS 39.
The Board also decided that these amendments should be developed directly through the Board as a stand-alone amendment to IAS 39.
Discussion at the January 2007 IASB Meeting
Analysis of Comment Letters on the Exposure Draft
The staff presented an analysis of comment letters received on the Exposure Draft of Proposed Amendments to IAS 32 Financial Instruments: Presentation and IAS 1 Presentation of Financial Statements (ED).
The Board discussed certain aspects of the comments received but no decisions with regard to amendments of the ED were made.
Project Plan
The Board discussed whether to proceed with this project or to await the outcome of the long-term project on Liability and Equity.
About half of the respondents had suggested widening the scope of the project in order to classify as equity additional instruments such as:
- Financial instruments puttable at no more that its fair value (for example, financial instruments puttable at book value and co-operative capital)
- Minority interests puttable at fair value
- Financial instruments puttable at fair value that are not in the most subordinated class but are subordinated to creditors, or financial instruments puttable at fair value that are in the most subordinated class but there exists another class of shares in the most subordinated class without the right to put
- Warrants (and other derivatives) to be settled by the issue of financial instruments puttable at fair value
- Financial instruments puttable at fair value with the right to mandatory dividend distribution or partnership remuneration.
The Board members pointed out that the scope of the project is the most critical issue and agreed to keep the scope narrow since otherwise this project could prejudice the outcome of the Liability and Equity project. The Board acknowledged that, accordingly, the project could only resolve the problems in some jurisdictions.
The Board decided to go forward with this project and directed the staff to prepare a paper on the scope issue for discussion at a future meeting.
Discussion at the April 2007 IASB Meeting
The staff informed the Board about its intended next steps in this project.
The staff proposed to separate the issues raised in the comment letters on the Exposure Draft (ED) Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation into two work streams:
1. Finalisation of the ED by addressing those issues raised in the comment letters that would not require a re-exposure of the ED
This will relate to issues such as:
- Clarification of what is meant by reference to fair value in the equity classification criteria
- Clarification of 'the most subordinated class' requirement
- Whether the issue price of financial instruments puttable at fair value must be at fair value, and whether transitional guidance needs to be included as to what that means
- The disclosure of the fair values of financial instruments puttable at fair value
- The effective date of amendments
Staff intends to bring a paper to the May 2007 meeting requesting decisions on these issues.
2. Research on those issues raised in the comment letters that might require a re-exposure of the ED
These issues relate to the scope of the amendments. Some respondents noted that criteria for equity classification within the ED are too restrictive and do not cover a number of instruments (such as partnership interests, membership interests in co-operatives, and development banks).
It is intended to bring preliminary considerations on these issues to the Board in June 2007.
Some Board pointed out that the narrow scope of the project had been well-considered and that under no circumstances it should be widened. Other Board members expressed the view that no further research should be performed on issues outside the scope but that this should be part of the equity and liabilities project.
With a majority of 9 votes the Board decided to go ahead with the current scope and to bring back in May 2007 a revised ED addressing the issues outlined under (1) above. In addition, the Board directed the staff to further investigate the issues outlined under (2) above for discussion at a future meeting.
The issues raised in the comment letters were not discussed at this meeting.
Discussion at the May 2007 IASB Meeting
Based on issues raised in the comment letters the Board continued its discussion on the Exposure Draft Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation (ED).
The discussion focussed on the basic characteristics (principles) underlying the ED.
The staff outlined that an instrument addressed in the ED:
- a. has a residual interest in that entity throughout the life of the instrument, and
- b. participates fully in the performance of the entity throughout the life of the instrument.
In this context the Board raised the question what fair value is being referenced to in the ED; the fair value of the instrument or the fair value of the entity.
After a thorough discussion there seemed to be a consensus that the fair value referenced to in the ED should be the fair value of the instrument and that this fair value does not necessarily reflect the pro-rata share of the fair value of the entity. It was noted that in many cases in an 'ongoing business' (that is, not a limited life entity at the point of liquidation) the fair value of the instrument is determined based on a formula. The fair value of the entity is not determined or not determinable since the instruments are not listed. Accordingly, the 'formula value' is the only relevant market value to determine fair value.
The Board pointed out that in case the fair value of the instrument differs from the pro-rata share of the fair value of the entity the instrument does not participate fully in the performance of the entity and therefore characteristic b) would not be fulfilled. One Board member noted that the initial wording was discussed in relation to limited life entities only.
The Board decided to stick with the basic characteristics but to improve the wording in the ED; in particular to clarify the fair value implications discussed at this meeting. Senior staff noted that in summary the ED should make clear for the instruments in question that 'absent the put we have an equity instrument'.
In addition the Board agreed the following:
- Partnership interests
Personal guarantees by partners (either general or limited) should be disregarded for classification purposes and with regard to the ranking among the holders of the most residual class of instrument. Such personal guarantees should be considered to be separate contractual arrangements.
- Presence of non-puttable instruments
The Board decided to maintain the criteria set out in the ED relating to the presence of non-puttable instruments, that is, one feature of being most residual is that if an instrument is puttable at fair value, then all other instruments in that class must also be puttable.
- Minority interests
The Board agreed to maintain the guidance in AG 29A of the ED with regard to the treatment of minority interest at consolidation level.
- Identification of issue price for old instruments / transition guidance
To be discussed at the June 2007 meeting.
The staff was directed to redraft the ED accordingly for discussion at a future meeting.
Discussion at the June 2007 IASB Meeting
The Board held a very brief discussion with the staff on the project. As a result of discussions between staff and individual Board members, it was apparent to the staff that additional analysis was necessary before the staff was in a position to bring a revised proposal to the Board. A brief discussion followed that summarised some of the challenges to the IAS 39 definition of equity that the staff is analysing. The staff expects to present its analysis at the July 2007 meeting.
Discussion at the July 2007 IASB Meeting
In May 2007, the Board tentatively decided that for a puttable instrument to qualify for equity classification, the instrument must, among other requirements, participate fully in the performance of the issuing entity in the period the instrument is outstanding (hereafter referred to as 'the Requirement'). The Board tentatively agreed that the full participation in the performance of the issuer can be best demonstrated when the instrument is issued and puttable at the fair value of the instrument.
Demand for an exception to the Requirement
Some constituents noted that the Requirement makes the scope of the proposed amendment too narrow because, in many situations, the issue price and/or the strike price of the put option of a puttable instrument is not simply defined as the fair value of the instrument. Instead those prices are the result of applying a formula or some other method, for example, the result of negotiation between the interested parties. They argue that if there is no exception to the Requirement, the proposed amendment will affect only a very limited number of entities.
In the view of those constituents, 'something less than full economic participation' would be sufficient for a puttable instrument to qualify for equity classification for instance, participation based on a formula.
The Board decided that any exception should be within the boundaries of paragraph AG 14A of the ED, that is, any exception would not apply to publicly listed companies and entities that hold assets in fiduciary capacity.
Scope of an exception to the Requirement
The Board then discussed what level of participation in the performance of the entity should be demonstrated by the formula to qualify for equity classification.
The staff presented various alternatives, but stated a preference for an approach under which full participation in the accounting performance of the entity (that is, the effect of items that are not recognised for accounting purposes are not taken into consideration) would be required for a puttable instrument to qualify for equity classification should the exception to the Requirement apply, as follows:
- 1. Instrument is both issued and redeemed at the pro rata share of the book value of the entity (as calculated under IFRS).
- 2. Instrument is issued at a fixed price, the comprehensive income of the entity is distributed in its entirety annually, or if not distributed allocated to the partners' or shareholders' capital account (that is, full profit sharing), and the instrument is redeemed at the same fixed price as it was issued at. (If losses have been incurred in excess of other reserves over the period the instrument is outstanding the fixed redemption price would be adjusted accordingly).
- 3. Instrument is both issued and redeemed at the pro rata share of the book value, however that book value is not calculated under IFRS, but instead under local law or local GAAP as dictated by the charter or the instruments terms and conditions.
The Board had a lengthy discussion without concluding on a preferred approach. Some Board members were concerned about widening the scope at all. Others were reluctant to allow book values under local law or GAAP (alternative 3 above).
Finally, the staff was directed to try to find a reasonable scope of exceptions taking into account staff views and the statements made at this meeting. If it would not be possible to find a solution the Board intends to release the amendments as currently drafted.
This issue will be discussed again at the September meeting.
Discussion at the September 2007 IASB Meeting
The Board re-examined the characteristics that result in puttable instruments being considered as the residual interest, i.e. to qualify for equity classification.
The Exposure Draft Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation (ED) identified the residual interest in the net assets of an entity by requiring all individual puttable instruments
- a) to be in the most subordinate class of instrument,
- b) to be issued and puttable at the fair value of the pro-rata share of the net assets of the entity, and
- c) to have neither a limited nor guaranteed return.
With regard to requirement b) above the Board tentatively agreed that the full participation in the performance of the issuer can be best demonstrated when the instruments are issued and puttable at the fair value of the instruments.
Some constituents noted that, in particular, requirement b) makes the scope of the proposed amendment too narrow.
The 'Revised Approach'
In response to these comments the staff presented the Revised Approach. The main feature of this approach is that the class of puttable instruments as a whole is required to represent the residual interest in the entity. Accordingly, the put price of the individual instrument would be of little relevance for classification of the class of puttable instruments as long as the class as a whole represents the residual interest in the entity. However, all individual instruments still need to be equal in all other respects.
The Revised Approach eliminates requirement b) and, accordingly, the definition of residual interest much more relies on requirement c) above.
The staff proposed that the ED should be modified to describe what type of return is characteristic of equity rather than only stating what type of return does not qualify for equity classification. The following amendment was proposed:
'The total return of the puttable instrument is based substantially on the net earnings or the change in net assets of the entity (excluding any possible effect the puttable instrument may have on net earnings or net assets). An example of a puttable instrument with a return that is not based substantially on the net earnings or the change in net assets of the entity is a puttable instrument that has a fixed or guaranteed total return to any extent, before or at liquidation'.
The staff drew to the attention of the Board that the definition of returns does not address the issue that there might other (less subordinated) instruments that are absorbing most of the variability in the performance of the entity and leaving only a predetermined (but slightly variable) amount of net earnings or net assets for the class of puttable instruments. To address this potential flaw the staff suggested including the following guidance in the ED:
'The variability of the total return to the class of puttable instruments is not substantially absorbed by another contract or financial instrument, or some combination thereof. If a determination cannot be made that these conditions are met, the puttable instruments are classified as liabilities.
Ordinary commercial contracts, like leases, mortgages, and franchise and license agreements may include provisions based on elements of the entity's performance (for example, a percentage of gross revenue). Contracts entered into on normal commercial terms with unrelated parties are unlikely to fall within the meaning of this test. For example, if commercial practice for lessors is to base rentals in part on a percentage of gross sales, and the percentage in the entity's lease is consistent with amounts charged in the are area, then the lease should not be considered to absorb substantial variability in net earnings or net assets.'
The Board agreed to proceed with the Revised Approach.
Mandatory dividends and partnership remuneration
The staff suggested that the ED should not provide guidance as to whether a mandatory dividend is a contractual obligation.
The Board agreed to this by majority vote but pointed out that the following principle should be clarified in the ED:
- If a mandatory dividend is required to be paid in the absence of profit the instrument does not qualify as equity classification.
- If a mandatory dividend is required to be paid only if sufficient profit is available such a clause should not prevent the instrument from being classified as equity.
Derivatives on puttable instruments and limited life obligations
The Board unanimously decided to retain the guidance in the ED that derivatives on puttable instruments or limited life entity shares are not equity.
Reclassification of instruments
The Board decided to include the following guidance on how to reclassify an instrument under the ED:
- On reclassification from liability to equity the instrument is classified as equity with a carrying value equal to its previous carrying value. There should be no gain or loss.
- On reclassification from equity to liability the equity instrument will be carried at cost while IAS 39 Financial Instruments: Recognition and Measurement requires initial recognition of a liability to be at fair value (paragraph 43). Any difference between the carrying value of the equity instrument and the fair value of the newly recognised financial liability should be recognised in equity.
Mandatory redemption
The staff noted that the ED does not address this issue explicitly but that the criteria in the ED (also under the Revised Approach) would not prohibit an instrument in which the embedded put is automatically exercised on the occurrence of specific certain or uncertain events (such as death or retirement) from being classified as equity.
There seemed to be a consensus that mandatory redemption on death or retirement does not prohibit an instrument from being classified as equity. One Board member noted that such clauses have been used for decades and that any change to this principle would have massive implications for many instruments currently classified as equity under IFRSs, i.e. would go far beyond this project.
Implications of the re-deliberations to obligations arising on liquidation of limited life entities
The Board unanimously agreed to the staff proposal to provide separate guidance for puttable instruments and obligations arising on liquidation of limited life entities to reduce complexity of the ED. Constituents had indicated that they have problems in identifying what criteria relates to which type of obligation.
Effective date and transition requirements
The Board tentatively decided the effective date to be 1 January 2009 with early adoption being permitted. The proposed amendments should be applied retrospectively with an exception relating to compound instruments in which the liability component is no longer outstanding.
Next steps
The staff was asked to prepare a revised ED including the Revised Approach and the decisions made on the other issues.
The Board intends to hold roundtable discussions on the revised ED in November 2007 in London. Based on the outcome of the roundtables the Board will decide whether re-exposure is required.
Discussion at the October 2007 IASB Meeting
Arrangements for Roundtables
At its September 2007 meeting, the Board decided to proceed with a revised approach to the Exposure Draft Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation and to discuss the proposed amendments at a public roundtable meeting. You can find Deloitte's report on that meeting Here.
The Board agreed that the roundtable discussions will take place in London on 12 November 2007. The discussions will be open to the public.
Participants will be asked to respond to the following questions:
- Does the staff draft address the types of financial instruments that should be addressed in a short-term limited-scope project? If not, what instruments should be addressed and why?
- Are the proposals operational? If not, why not and what changes would you propose?
- Are there any issues that are not addressed in the staff draft that should be addressed? If so, what are they and why should they be addressed?
One Board member noted that it was important to clarify that the purpose of the roundtable was exclusively to discuss the proposed amendments and not to raise additional issues. No Board member objected to that statement.
November 2007: IASB holds roundtable on puttable instruments
On Monday 12 November 2007, the IASB conducted a public roundtable on a revised staff draft of an amendment to IAS 32 on whether financial instruments puttable at fair value and obligations arising on liquidation should be classified as debt or equity. Here is a brief report:
- Thirty-three individuals and organisations participated in the roundtable, as did eight IASB members and several staff.
- The revised draft amendment can be downloaded from the IASB's Website (PDF 888k).
- During the roundtable, the IASB indicated that it does not consider the changes from the June 2006 Exposure Draft significant enough to warrant re-exposure.
- While most participants agreed that amendment of IAS 32 for puttable instruments is needed, and many spoke in favour of the revised draft amendment, numerous technical issues were raised with respect to the proposal. Staff indicated that it plans to consider whether and how to reflect the views expressed at the roundtable in a revised draft of amendments to IAS 32 that it plans to present at the Board's December 2007 meeting.
- The IASB is aware of the need to finalise the amendment as soon as it can to allow early adoption for many entities. The Board intends to post a near-final draft of the final amendments on its website when available.
Discussion at the November 2007 IASB Meeting
On 12 November the Board held two round table discussions on a revised Exposure Draft (the Staff Draft).
The staff presented a summary of the issues raised at these meetings. The staff concluded that the majority of participants supported the Staff Draft and that most of the issues can be resolved by revising the wording.
The staff proposed the following ways forward:
- Incorporate in the Staff Draft the comments made by constituents
- Send a pre-ballot draft to Board members before the December meeting
- Board to discuss and vote on the pre-ballot draft at the December meeting
- Send a ballot draft to Board members after the December meeting
The Board agreed.
Discussion at the December 2007 IASB Meeting
The purpose of this session was to discuss with the Board issues that arose during the roundtables on the staff draft on puttable instruments and to summarise significant drafting changes. The discussions were based on a pre-ballot draft that was not available to the public.
In the first part of the session the following issues were discussed:
- Financial instruments that include other contractual obligations
Constituents questioned why paragraphs 16A and 16C of the staff draft were different, especially with respect to the condition in 16A(d) that the instrument 'must not include any other contractual obligation to deliver cash' whilst paragraph 16C does not include that condition. The staff noted that believes that it is appropriate to have different conditions, but changed the title of the section containing 16C to 'components of instruments' to clarify that such instruments can have other contractual obligations that would need to be separated. The Board agreed.
Another issue was if mandatory dividends and partnership remuneration meet the definition of a contractual obligation. The Board agreed in September 2007 not to deal with this issue and decided not to revise its decision.
- An instrument holder in the role of owner and non-owner
Constituents described situations where part of the remuneration is for services and hence they do not compensate the holder for the role as owner, but this would not automatically lead to liability treatment of the whole instrument and analysed separately. The Board agreed this is correct, but as suggested by one Board member this must be ring-fenced to avoid abuse, i.e. prohibit excessive 'service remuneration'. The draft will be amended to make clear that this remuneration must be an appropriate return for the services provided.
- The meaning of 'fixed', 'guaranteed' or 'restricted' to describe an instrument's return
The staff draft caused some confusion with regard to the meaning of 'fixed', 'guaranteed' or 'restricted' return. As a result the last sentence of paragraph 16A(e) has been removed in the pre-ballot draft. The Board agreed to the deletion.
- Interaction of the proposed amendment and the requirements in IFRS 2 Share-based Payment
Constituents also asked about the interaction of IFRS 2 and the proposed amendment. There might be situations where the provisions in IAS 32 lead to an equity balance sheet presentation while they would be a liability in accordance with IFRS 2. Some Board members expressed concerns about the apparent conflict with the Framework of the proposed amendments. After being reminded by the Chairmen of the Board that this was not meant to be a major project the Board members agreed to the revised wording in the ballot draft.
- The proposed disclosure requirements
The staff was split on the disclosure of the fair value of those instruments. One Board member said from the perspective of users this information is useful. The Board agreed to keep this disclosure requirement. Additionally, it was agreed to include a consequential amendment to IFRS 7 Financial Instruments: Disclosure to make clear that the instruments captured by the IAS 32 amendment are scoped out of IFRS 7.
- Application of the proposed amendment's requirements to specific mutual fund structures
The staff asked the Board if they have any questions on the application of the amendments to mutual funds. The Board decided not to address this issue specifically.
- Whether it is appropriate to analogise to the exception in the proposed amendment
The staff asked the Board if the standard text should contain guidance that the exceptions resulting from the amendment shall not be analogised. Some Board members questioned if such an amendment should better be made to IAS 8 as it seems to be a principle that exceptions should not be analogised. It was noted that this is more than a minor amendment. Nevertheless that clarification should be included within this amendment due to the dynamics in the structuring industry. The Board agreed.
- Amend the draft to deal with situations in which significant amount of the profit is distributed via rebate (not mentioned in the Agenda Paper)
This was an additional item brought up by the staff with regard to rebates being granted to owners. It was suggested amending the application guidance to make clear the Boards intentions. The Board agreed.
After this, the staff presented to the Board significant drafting changes made to the published staff draft. The Board accepted all changes made.
Staff then asked if the Basis for Conclusions should contain a cost-benefit analysis. Staff noted it is standard procedure to include such an analysis. The Board agreed.
The Chairman then took an indicative vote. Two Board members indicated they would dissent.
The staff informed the Board they will circulate a ballot draft and if that is accepted a Near-final Draft will be published in the subscribers' area of the IASB's website by 24th of December latest.
Discussion at the January 2008 AISB Meeting
No papers were available for this session.
The Board held a brief discussion of a drafting issue on puttable financial instruments. The issue involved a proposed change from the staff draft used at the December 2007 public roundtable. After discussion, the Board agreed to return to the principle in the staff draft.
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