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Financial Instruments with the Characteristics of Equity

Date recorded:

Classification of instruments an entity will settle by issuing its own shares

The Boards continued their discussion from the December IASB/FASB meeting on the classification approach for instruments that an entity is required to settle (and has the ability to settle) by issuing its own shares.

The Boards discussed the Approach 4.2 that would require classification as equity for more instruments than Approach 4.0 and fewer instruments than Approach 4.1 (as defined during previous joint meetings). This Approach was developed as a compromise that should alleviate IASB and FASB differences. The particular instruments that would be classified as equity under Approach 4.2 (and not Approach 4.0) would include rights issues and 'regular-way' forward contracts to issue shares that are outstanding for a relatively short time, stock-purchase warrants issued solely for the purpose of raising additional capital as well as mandatorily convertible preferred shares (convertible to ordinary shares). The requirements of Approach 4.2 would result in classifying convertible instruments as liabilities in their entirety.

Some IASB members were troubled that these exceptions to the classification criteria have no conceptual basis. The staff replied that they were exceptions to accommodate the concerns by both of the Boards. The IASB members were particularly concerned that some of these exceptions might lead to otherwise identical stand-alone instruments to be treated differently based on to which other instruments they were attached.

One IASB member was particularly troubled by the basic principles underlying the classification approach and expressed his view that first the answer to a more fundamental question whether writing an option on own shares should be classified as equity or as a derivative liability should be addressed. Based on his view, answer to this question should be the basis for the development of a classification approach.

In an indicative vote, the IASB supported classification of forwards/options to issue fixed amounts of shares for cash as equity (15 votes), whereas the FASB was opposed (two votes against three).

Another IASB member suggested that the basis for the classification should be whether there is a 'determinable obligation' of the entity and should be not dependent on the short-term/ long-term horizon.

The FASB Chairman pointed out that the issue took the Boards back to the 'dilution' versus 'solvency' perspective the Boards already discussed many times. He underlined that this was the tension point between the FASB and the IASB as the IASB was in the 'solvency view' whereas the FASB was in the 'dilution view'. As the IASB was unanimous in this view and the FASB was split, the FASB Chairman expressed his support for the classification approach 4.2 on the conditions that overall classification principles were tightened and additional disclosures that show dilution effects were provided. The FASB chairman acknowledged that the IASB was 'not particularly unhappy with IAS 32' but the US GAAP needed a change. Therefore, he expressed his willingness to work for a converged compromise.

In a protracted debate, various IASB members argued for the 'solvency' view. In particular these members were concerned by the impact of the classification of these instruments as liabilities on the performance statement and negative impact that could have on usefulness of the information provided. The IASB chairman and FASB Chairman tried to find a common ground that the majority of both Boards would be able to support. They agreed that the dilution issue could be addressed by a set of comprehensive and consistent disclosures that would capture wealth transfers and address the issue of using operating cash flows to re-purchase the shares (based on issued call options).

One FASB member was particularly worried that the IASB members come to each meeting with a new larger set of items that should be classified as equity. The IASB members responded that they become concerned with the implication of the classification principles when they see particular application on a set of examples.

Another FASB member was troubled by the effect of the proposed classification approach on convertible debt and possible arbitrage. She proposed a classification approach based on the improvement of IAS 32 (that is, bifurcation) and not based on a completely new classification approach. Several IASB members agreed. Nonetheless, other IASB members disagreed as they believed that IAS 32 had its own problems that needed to be addressed. They agreed that the result of the classification might be very similar but urged the Boards to develop a new approach.

Finally, both Boards asked the staff to develop a modified classification approach ('Approach 5') based on improved and modified IAS 32 requirements, particularly for cash-settled instruments and better articulation of the fixed-for-fixed rule (the Boards briefly discussed the 'specified-for-specified' rule, a modification of the fixed-for-fixed rule designed to make it more granular). The Boards agreed that the staff should include in its analysis the classification of these instruments in the consolidated financial statements as well as treatment of convertible instruments. In addition, at the same time the staff should prepare an analysis of disclosure requirements that would address the dilution aspects of the issue (including wealth transfer and its disclosure in the Statement of Changes in Equity) and granularity of these disclosures.

The Boards will discuss the new classification approach at the regular February meeting. The remaining issues that were not discussed during the January meeting will be addressed at a separate special meeting in February).

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