The staff described a new proposal (Approach 4.1) for distinguishing between liability and equity instruments and asked the Boards whether they were interested in pursuing this approach. Staff explained the difference between Approach 4.1 and Approach 4, which the Boards had discussed previously. Under Appriach 4, shares that are issued pursuant to the contract (that is, all share-settled instruments) would be classified as liabilities regardless of their terms. Under the new Approach 4.1, share-settled instruments would be subject to a separate classification principle, under which the shares that an entity is not using as currency would be classified as equity. In particular, an instrument required to be settled by issuing equity instruments would be equity unless:

• (a) either party has a cash settlement option,
• (b) it requires net settlement in shares or either party has a net settlement option, or
• (c) the contract exposes either party to risks of changes in value other than those resulting from share price changes, time value of money, counterparty performance risk, and possibly foreign currency.

This classification principle would result in equity classification of certain share-settled instruments like preferred shares convertible into common shares, forwards to sell shares, physically settled written call options, and stock options. These instruments would have been classified as a liability under Approach 4.

Puttable or mandatorily redeemable instruments would be classified as equity if they are redeemable upon death or retirement, or upon the holder ceasing to participate in the activities of an entity. All other puttable or mandatorily redeemable instruments would be separated or classified as liabilities in their entirety.

Some Board members questioned whether convertible debt instruments should be classified as liabilities as proposed under Approach 4.1 or whether the convertible instrument should be bifurcated. Some suggested that this issue may be better addressed as part of the Financial Instruments Project.

Several members raised concern about the arbitrage and structuring opportunities with Approach 4.1, including unstated cash settlement features. For example, Approach 4.1 would allow an entity to avoid liability classification by writing a gross physically settled written call option (which would be classified as equity) and not having sufficient authorised and unissued shares available to satisfy the contract, in which case the entity would pay the holder cash instead of shares. The economics of the transaction would be the same as if the issuer had written the derivative to be cash settled; the derivative to be cash settled however would be classified as a liability.

Some members from both Boards raised concerns that under Approach 4.1 the information about the effects of dilution by particular instruments to shareholders would not be reflected in the financial statements. It was suggested that shareholders should be informed about the dilutive effect of certain instruments through appropriate presentation in the financial statements.

It was also explained that in relation to developing a definition of a liability in the conceptual framework that is consistent with Approach 4.1, the staff intended to keep the definition of a liability similar to what is in the current framework (that is, a liability requires a transfer of cash or assets) and to provide exceptions to the definition for share-settled instruments classified as a liability and for cash-settled instruments classified as equity.

Most members agreed to pursue Approach 4.1 and to consider ways to resolve arbitrage issues inherent in Approach 4.1.