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Financial instruments with characteristics of equity

Date recorded:

Agenda Paper 5: Cover note

The Technical Manager informed the Board that the purpose of the meeting was to identify to what extent the requirements in IAS 32 captured the features needed to make the assessments the Board identified in the previous meeting and whether there were any exceptions, inconsistencies or gaps in those requirements. He said that these issues would be addressed by identifying, confirming or correcting and reinforcing the underlying rationale of the distinction between liabilities and equity in IAS 32 before attempting to improve consistency, completeness and clarity of the requirements.

One Board member had a comment on the notion in the cover paper that the Board would have to discuss the requirements in IAS 32 that addressed the interaction of contractual rights and obligations with regulatory and legal overlays. He said that any contract would have to be within the regulatory or legal system, so the requirements should look at regulatory or legal requirements first before looking at the contract. Another Board member agreed and said that introduction of legal requirements (e.g., a minimum dividend) could change the contractual obligations. The Technical Manager acknowledged the issue but said that this would be a discussion for a later stage of the project.

Agenda Paper 5A: Analysis of IAS 32 and outline of potential approaches

The Technical Manager introduced the agenda paper by saying that it reiterated the features of claims against an entity and the reasons why they were relevant to users in assessing the financial position and the financial performance.

  • Assessment A was an assessment of the extent to which the entity was expected to have the economic resources required to meet its obligations as and when they fell due. The main feature relevant to assessment A was the timing of the required settlement. The type and amount of economic resources required were secondary features.
  • Assessment B was an assessment of the extent to which an entity had sufficient economic resources to satisfy the total claims against the entity at a point in time. The primary feature of this assessment was the amount of resources required. The timing of required settlement was irrelevant. The assessment distinguished between claims that were independent of the availability of the entity’s actual resources and those that were not.
  • Assessment X was an assessment of the components of changes in economic resources, other than changes that resulted from issuing claims, or distribution from settling claims.
  • Assessment Y was a comparison of the returns on the entity’s economic resources to the promised returns of the entity’s claims.

He said that none of the features was applied consistently, i.e., a feature might be relevant for one assessment but not the other. The definition of a liability in IAS 32 implied that a transfer was required prior to liquidation. However, the IASB introduced an exception for some puttable financial instruments. IAS 32 classified instruments with a contractual obligation to deliver a variable number of equity instruments as liabilities. In the staff’s view, the IASB had based this decision on the obligation to pay a specified amount independent of the entity’s economic resources.

One Board member asked whether the cumulative preference shares referred to in the agenda paper meant that there could not be any dividend payments on other shares either. The Technical Manager confirmed that and added that payments of the cumulative preference shares had priority over ordinary shares on liquidation.

The Technical manager continued by stating that the staff had developed three approaches to improve IAS 32.

Approach Alpha focused the distinction between liabilities and equity on features that were relevant to Assessment A. This approach was most consistent with the proposed definition of a liability in the Conceptual Framework exposure draft. It would, however, represent a change to IAS 32 with respect to obligations to deliver a variable number of own equity instruments.

Approach Beta focused the distinction between liabilities and equity on features that were relevant for Assessment B and Y. This approach would be the least consistent with the proposed definition of a liability in the Conceptual Framework exposure draft. It would require significant changes in both IAS 32 and the Conceptual Framework.

Approach Gamma focused the distinction between liabilities and equity on features that were relevant for Assessments A, B and Y. This approach was the most consistent with the current requirements of IAS 32, it might, however, affect the classification of some obligations to transfer economic resources on liquidation. Also, the proposed definition of a liability in the Conceptual Framework exposure draft would have to be expanded to include other features.

He said that the focus on these approaches did not mean that the other features were not relevant.

One Board member suggested identifying distinct instruments and determining if they were equity or liability under each of the approaches. He said that the challenge of the project would be to capture instruments with many features. He suggested exploring the features and approaches in a discussion paper. He said that the Brazilian regulator would probably prefer Approach Alpha.

A fellow Board member expressed a preference for Approach Gamma as an obligation to transfer economic resources prior to liquidation or to transfer an amount that was independent of the entity’s economic resources would be classified as liability. She also liked that share-settled instruments were captured by this approach. The Technical Manager acknowledged that and said that the specified amount was the determining factor and that under Approach Gamma cumulative preference shares would be classified as liabilities.

One Board member asked whether staff intended to continue with all three approaches. He expressed strong concern about changing existing equity and liability classifications drastically. He therefore preferred Approach Gamma but said that exemptions would still be required under this approach, e.g., for the classification of partnership capital. Alternatively, IAS 32 could be left unchanged and only specific problems, e.g., NCI puts, could be addressed separately. The Technical Manager acknowledged the comment and replied that a discussion paper should describe more than one approach to ensure that constituents understood that none of the approaches solved all the problems.

A Board member added that the Board could indicate a preference for Approach Gamma in a discussion paper and discuss the impact on IAS 32. The Technical Director acknowledged that and said that the approach could be tested towards a range of instruments. A Board member agreed and said that the issues experienced on the previous attempts to change IAS 32 should be taken into consideration. The Technical Manager said that the Board would still need to make a decision what the distinction should be based on and stressed that Approach Gamma was not similar to the ‘basic ownership approach’ that had been rejected previously. Approach Gamma would not lead to only one class of equity with the remainder classified as liabilities.

One Board member said that he would not be comfortable to express a preference for one of the approaches without having collected feedback by way of a discussion paper. A fellow Board member said that IAS 32 had not caused problems for preparers but there was confusion among investors. The Technical Manager assured that the investor perspective would be considered in the project, especially by addressing the diversity in practice. The Board member replied that Approaches Alpha and Gamma would still treat share-based and equity-based settlement differently and only Approach Beta would solve this inconsistency. He advised the staff to also consider IFRS 2 issues in the project. A fellow Board member agreed and supported publication of a discussion paper including giving an explanation of why a discussion paper was needed. She said that she saw the benefit of Approach Beta but that sub-classification could also be introduced under Approach Gamma. One Board member said that each Approach should present the benefit for current practice issues in order to get consent from constituents. He said it would be consistent to proceed with an approach that was in line with the Conceptual Framework exposure draft. The Chairman replied that the Board should not be constrained by the Conceptual Framework exposure draft.

One Board member preferred Approach Beta as Approach Gamma, to him, was an artificial combination. He said that he did not see the need for a binary classification.

The Technical Manager concluded that the staff would examine the effects of the approaches on more and more instruments. One Board member replied that she liked to have a principle based on simple instruments before looking at more complex instruments. The Technical Director agreed but said this would be difficult for derivatives which were to be discussed in the following meeting.

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