Financial Instruments with the Characteristics of Equity

Date recorded:

Broad classification questions

The Board considered particular financial instruments and their desired classification in order to be able to determine a principle underpinning the model being developed.

Firstly, the Boards reaffirmed all their decisions already made during the project.

The Boards also agreed that nominally perpetual instruments issued by limited-life entities should be classified as equity in the separate financial statements of the issuer.

The Boards agreed that, consistent with the previous decisions, contracts that require issuance of specified number of puttable and mandatory redeemable equity instruments for a specified price (which are classified as equity in accordance with previous decisions) and contracts covering derivatives classified as equity would be classified as equity. On the other hand, contracts over puttable instruments that would be bifurcated when issued would be classified as a liability.

Contracts that require an entity to issue a specified number of equity instruments in exchange for no future compensation (prepaid instruments) would be classified consistently with contracts that require specified-for-specified issuance of equity instruments (see previous paragraph).

The Boards also agreed that mandatorily convertible preferred shares convertible into specified number of perpetual equity instruments or specified number of puttable or mandatory redeemable equity instruments would be classified as equity.

Finally, both Boards agreed that the classification of an instrument in a subsidiary's financial statements should be carried forward in the consolidated financial statements unless the nature of the instrument changes in consolidation because of arrangements between the instrument holder and another member of the consolidated group. If the nature of the instrument changes in consolidation, classification should be reconsidered in the consolidated financial statements.

Puttable shares and gross-up of freestanding written put options

The Boards decided that puttable shares should be separated into a share and a written put option, and that the written put option should be reported net as a liability even if the exchange is specified-for-specified. The Boards further decided that all freestanding written put options should be reported net as liabilities.

One Board member preferred grossing up of the separated put option as he believed that the agreed solution should facilitate structuring of the debt as equity. However, most Board members disagreed as they believed that any alternative that contains grossing up could be counterintuitive and extremely complex to implement.

The Boards agreed to add special provisions to prevent abuses (such as an example that issuing shares and an in-the-money put option at the same time to the same party should be linked as treated as a single debt instrument).

Convertible debt

The Boards considered bifurcation of convertible debt. The IASB preferred bifurcation of convertible debt as Board members believed that such treatment is more consistent with the overall IASB model. Moreover, the IASB members believed that the existing requirement for bifurcation of convertible debt is well understood, used in practice, and perceived as decision-useful. As one IASB member noted, even if convertible debt were classified as liability in its entirety under this project, it would be bifurcated under the proposed guidance for classification and measurement of financial liabilities, which would then require a new set of conditions for bifurcation and result in additional complexity.

On this basis the IASB decided to retain the conditions for bifurcation of convertible debt. Views of FASB members were divided, with some members preferring measurement of convertible debt at fair value through net income in its entirety, and others preferring bifurcation. Finally, the FASB narrowly decided to proceed with bifurcation.

The Boards also considered the methodology for bifurcation. Some Board members preferred a simplified bifurcation method by which the debt component would be allocated on the basis of a 'plain vanilla' instrument with the same maturity date, and the interest rate would be the rate of nonconvertible bond of comparable credit quality from the same issuer (with the remainder allocated to the equity component). Other Board members preferred to retain the IAS 32 bifurcation method, in which any interdependency is allocated to the liability component. Most Board members preferred the simplified method, subject to additional analysis by the staff that would consider potential consequences of such an approach.

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