Financial Instruments with Characteristics of Equity (Liabilities and Equity)
At the Joint Board meeting in October, the boards decided to begin deliberations on their project financial instruments with characteristics of equity using the principles underlying the perpetual approach (that is, no settlement feature and entitlement to pro-rata share on liquidation of the issuing entity) and the basic ownership approach (that is, most subordinated instrument and entitlement to percentage of net assets).
The staff explained that the Agenda Paper divided the seven previously identified classification issues into two parts, as follows:
- Part 1: Issues that could potentially be resolved at this meeting
- Should perpetual basic ownership instruments be classified as equity?
- Should other perpetual instruments be classified as equity?
- Should derivatives held or issued by an entity be classified as equity if the underlying is the entity's own equity instruments?
- Part 2: Issues that likely would require further analysis and deliberations at future meetings
- Which hybrid instruments should be separated into equity and non-equity components?
- How should redeemable ownership instruments be reported?
- Should instruments that are classified as equity in the financial statements of a subsidiary retain that classification in the consolidated financial statements?
- How do the Boards want to address income statement presentation (especially disaggregation of gains and losses on derivatives and hybrid instruments)?
On the Part 2 issues, the staff sought initial reactions to confirm that these were the right issues to be analysed.
Part 1: Issues that could potentially be resolved at this meeting
Should perpetual basic ownership instruments be classified as equity?
The staff asked the Board whether it considered perpetual basic ownership instruments as equity. One of the Board members questioned whether the notion of 'ultimate risks and ultimate rewards' used in the Agenda Paper was the characteristic that made the staff believe it is equity. The staff answered that the definition of a basic ownership instrument as defined in the discussion paper was the driver for this conclusion.
In the end, the Board agreed that perpetual basic ownership instruments are equity.
Should other perpetual instruments be classified as equity?
The staff continued to explain that FASB prior to issuance of its preliminary views debated whether perpetual instruments with preference to dividend or in liquidation should be classified as equity. It was noted that finally the FASB decided to classify them as a financial liability because it was not able to resolve the issue of economic compulsion. One Board member questioned whether economic compulsion creates a present obligation and hence, whether an perpetual instrument where the features created economic compulsion met the definition of a liability under the Framework.
After a brief discussion, the Board agreed with the staff proposal to treat such perpetual instruments with dividend or liquidation preference as equity.
Should derivatives held or issued by an entity be classified as equity if the underlying is the entity's own equity instruments?
The staff reminded the Board of the two approaches to accounting for derivatives over own equity instruments it previously focussed on:
- Classify indirect ownership instruments settled with equity instruments as equity
- Classify all derivatives over own equity as assets or liabilities
It was noted that FASB decided that such instruments should not be accounted for as equity leaving the issue of accounting for employee stock options open. Staff informed the Board that the decision whether employee stock options are within this scope of this project would be deferred to a future meeting. Some Board members saw no different characteristic in employee stock option that would justify a different accounting treatment. One Board member noted that classification as liability or asset would be in line with the concept of basic ownership instruments, but that this treatment would violate the Framework. Another Board member noted that this is true only for the current definition.
The Board agreed by majority vote that derivatives over an issuer's own equity instruments should be classified as assets or liabilities.
Part 2: Issues that likely would require further analysis and deliberations at future meetings
Which hybrid instruments should be separated into equity and non-equity components?
Staff noted that a hybrid instrument was an instrument that had both equity and non-equity features. It highlighted that such instruments would be split up if such an instrument required payment and after that payment an equity instrument remained outstanding. Further it noted that some Board members wanted puttable instruments and bonds with a conversion option for a fixed number of own equity instruments. The staff was asked to consider what was meant by a 'fixed' number as this would create difficulties in applying the current guidance in IAS 32 in practice.
How should redeemable ownership instruments be reported?
The Board discussed what was meant by a 'redeemable' instrument, that is, was redemption an option or a requirement. No decisions were made.
Should instruments that are classified as equity in the financial statements of a subsidiary retain that classification in the consolidated financial statements?
The Board discussed two alternatives:
- Carry over the classification from the subsidiary's financial statements (unless nature of instrument is altered by arrangements between holder and other group members)
- Always reconsider classification from the perspective of the consolidated financial statements
Some Board members believed that only perpetual instruments should be accounted for on the carry over alternative. For all other instruments consolidation would trigger reassessment.