Financial Instruments with Characteristics of Equity research project — Agenda paper 5
The purpose of this session was to continue discussions on the Financial Instruments with Characteristics of Equity (FICE) project. The staff presented the following agenda papers:
- Summary of discussions to date — Agenda paper 5A
- Derivatives over own equity — Agenda paper 5B
- Applying the Gamma to asset/equity exchange derivatives — Agenda paper 5C
- Applying the Gamma to liability /equity exchange derivatives — Agenda paper 5D
The Board was asked to comment on the staff analysis and their recommendations.
Financial Instruments with Characteristics of Equity research project — Summary of discussions to date — Agenda paper 5A
The research phase of this project involved evaluating potential ways to improve the classification of liabilities and equity, and the related presentation and disclosure requirements. The Board has explored the features to distinguish liabilities and equity: (i) the type of economic resources required to settle the claim; (ii) the timing of the transfer; (iii) the amount required to be transferred; and (iv) the priority of the claim relative to other claims.
The Board has been developing an approach (labelled Gamma, see discussion in February 2016), which distinguishes claims based on a combination of these features and would lead to outcomes broadly aligned with IAS 32. In April 2016 the Board discussed separate presentation requirements for liabilities that depend on a residual amount and the specific requirements for determining the amount to be attributed to classes of equity other than ordinary shares.
Appendix A included a summary of three approaches and Appendix B a summary of classification outcomes for some simple instruments.
Financial Instruments with Characteristics of Equity research project — Derivatives on “own equity” — Agenda paper 5B
This paper provides a summary of how the GAMMA approach would apply to the classification and presentation to derivatives on own equity.
Derivatives on own equity
The staff indicated that the characteristics of derivatives on own equity that distinguishes them from other derivatives is that one of underlying financial instruments of the exchange meets the definition of equity. The financial reporting consequences of the equity leg are different from the asset or liability leg because in the first case changes in equity do not meet the definition of income and expense. For assets/equity exchanges, both of the underlying financial asset to be received and the underlying equity to be delivered are not existing financial assets or equity of the entity. For liability/equity exchanges, the financial liability or equity that was to be extinguishes when the contract was settled must be an existing financial liability or equity of the entity. In addition, a derivative on own equity might also be conditional on future events. The staff analysis will focus on unconditional contracts and conditional contracts on events within the control of the counterparty.
The Gamma approach
The staff explained that the Gamma approach focused the distinction between liabilities and equity on both (a) the timing of required settlement; and (ii) the amount of the obligation. Under this approach, a liability includes an obligation: (a) to transfer economic resources at particular points in time other than at liquidation; or (b) for a specified amount independent of the economic resources of the entity. All other claims would be classified as equity. However, the Gamma approach did not help to determine whether the contract should be classified in its entirety or separately (because this is a unit of account issue). The staff explored in the agenda paper the following approaches to classify derivatives on own equity: (a) required a detailed componentisation of derivatives; b) required all derivatives to be classified as assets or liabilities; and c) classify standalone derivatives in their entirety as either equity or not equity, using classification criteria based on both legs. The staff noted that the first approach had conceptual and operational challenges due to its complexity. The second approach would increase the issue of recognising changes relating to underlying equity leg as income or expense and would be inconsistent with the classification of standalone obligations to issue a fixed number of ordinary shares as equity.
The staff recommended that the Gamma approach should continue to classify derivatives in their entirety as either equity, or as assets or liabilities. The staff believed that this would be consistent with the existing approach in IAS 32.
The Board supported the staff recommendation.
There was general agreement with the staff recommendation with not pursuing further full componentisation of derivatives. Most comments raised by the Board sought clarification of aspects of the agenda paper. The staff said that they had yet to consider presentation, however, they emphasised that presentation would reflect the decision not to componentise derivatives.
Some Board members agreed with the staff analysis and proposal, stressing that IAS 32 was not fundamentally broken and they were just trying to address some particular challenges. It is also important to maintain consistency with IFRS 9 and other standards—there are no other standard requiring that derivatives be separated into components. Users view derivatives as a whole.
The most common concern raised was whether the approach was appropriate for foreign currency issues. Some Board members noted that full componentisation would be challenging and difficult; however, not separating the effect could not help to improve performance reporting. Another comment was that the staff should analyse whether there was something particular with foreign currency that could merit separate treatment. The staff said that they would still try to achieve the main objective and consider whether they could find a solution while analysing the presentation issues.
Some Board members asked that future agenda papers should include more detail discussion around the accounting (i.e. debits and credits) so that they can better understand the implications of the staff proposal.
Financial Instruments with Characteristics of Equity research project — Applying Gamma to asset/equity exchange derivatives — Agenda paper 5C
The staff presented in this agenda paper their analysis as to how the Gamma approach could be applied to classify asset/equity exchange derivatives in their entirety.
IAS 32 classified asset/equity derivative contracts in their entirety using the fixed-for-fixed condition. Any amount that was not settled by the exchange of a fixed amount of cash (or other financial asset) or a financial asset for a fixed number of the entity’s own equity instruments was a financial asset or a financial liability.
The staff considered that asset/equity exchange derivatives would be classified as equity under the Gamma approach if it does not require the entity to transfer cash or other financial assets other than at liquidation and the amount of the derivative depends on the residual amount. On the other hand, asset/equity exchanges derivatives would be classified as liabilities if they are net-settled in cash or they require the entity to deliver a variable number of equity instruments. One of the challenges was to determine whether the derivative as a whole was for an amount independent of the entity’s economic resources or for an amount that depends on the residual amount.
The staff considered that classifying derivatives on own equity using a strict form of fixed-for-fixed would be a better application of the Gamma approach than classifying all (or some) variable-for fixed derivatives as equity. They preferred this because (a) the fixed-for-fixed principle provides a clear distinction between what should be classified as equity and what should not; (b) some of the approaches to the separate presentation requirement for equity might not best depict the asset leg variability that exist is such contracts; (c) the separate presentation requirements within equity would not sufficiently differentiate the items that are not equity-like from other changes of classes of equity that depend solely on the residual amount; and (d) it would be more consistent with IAS 32.
The staff recommended applying a strict form of fixed-for-fixed approach and mitigate the challenges by requiring additional presentation requirements. The staff suggested requiring that (a) liabilities that depend on the residual, including embedded derivatives, be presented separately; and (b) attribute amounts within equity to classes of equity other than ordinary shares.
The Board supported the staff recommendation.
The main comments were similar in nature as those discussed in agenda paper 5B.
In relation to the issue of foreign exchange, one Board member thought that it would be important to analyse whether it would be possible to draw a distinction between transactions in which an entity decides to operate in foreign currency from transactions in which an entity does not have that option (for example if an entity can only issue a convertible bond in US dollars but has a different functional currency).
Another concern noted was that the agenda paper explained that under the gamma approach, net share settled fixed-for-fixed contacts would be classified as equity (see paragraph 21) while under IAS 32 would be classified as liability. The staff indicated that they could not find the rationale in IAS 32 for that conclusion; however, they were trying to build a rationale for the gamma approach so that the classification would be based on the key features of the transaction, in this case (form over substance) whether the entity is obliged to pay cash.
One Board member pointed out that classifying a contract in its entirety as a liability even though it has some equity elements should not be an issue. If a contract has at least some elements of liability it should be considered a liability as a whole, while equity classification would require that contracts fulfils the requirements in its entirety.
Financial Instruments with Characteristics of Equity research project — Applying Gamma to liability/equity exchange derivatives — Agenda paper 5D
The paper analysed how the Gamma approach could be applied to classify liability/equity exchange derivatives in their entirety. The Board was asked to comment on the staff analysis.
The staff thought there are two different types of liability/equity exchange derivatives—those to redeem or repurchase a liability in exchange for issuing equity and those to redeem or repurchase equity in exchange for a liability.
The staff thought that liability/equity exchanges would be classified as equity under the Gamma approach if it does not require the entity to transfer cash (or other financial assets) other than at liquidation and the amount of the derivative depends on the residual amount. The staff also noted that two additional conditions must be met: (a) the derivative redeems or repurchase a liability in exchange for issuing equity, and is physically settled; and (b) the amount of the derivative is determined by receiving a liability of a fixed amount in exchange for delivering a fixed amount of equity instruments.
The staff thought there are challenges in this approach similar to the ones discussed in agenda paper 5c). The staff considered that the decision as to whether or not to extend the fixed-for-fixed requirements to all liability/equity exchanges is more complicated than asset/equity exchanges, but it would be inconsistent not to do so. The staff suggested amending the redemption obligation requirement when they do not meet the fixed-for-fixed-condition.
The staff recommended that the Gamma approach have a requirement similar to the existing redemption obligation requirement in IAS 32. The staff also recommended continuing to apply a fixed-for-fixed condition for classification of derivatives as liabilities or equity. The staff would clarify and reconcile the interaction of: a) the fixed-for fixed condition; b) the compound instrument requirements; and c) the redemption obligation requirements. The staff would present at future meetings their proposal for separate presentation requirements.
The Board approved the staff recommendations.
During the discussion the staff clarified that they would need to add further requirements to obtain consistent application in different transactions that have specific features. The staff indicated that they wanted to capture first the contracts that should be classified as a liability and then equity classification would be a residual.
Some Board members noted that even though they agreed with the logic followed by the staff in presenting the agenda paper, it would be important to clarify the mechanics of the transaction. Particularly, they were concerned that this new approach be a significant change from IAS 32 and it would not necessarily be intuitive. Also, it would be important to show the benefits of the staff proposal over the current accounting practices.