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Financial instruments with characteristics of equity

Date recorded:

Non-derivative equity instruments with complex payoffs - Agenda paper 5

Background

In this paper, the Staff explored potential ways to provide useful information about non-derivative instruments with equity hosts with complex payoffs. This type of instruments had not been discussed by the Board before and was identified during the review of a pre-ballot draft of the Financial Instruments with Characteristics of Equity Discussion Paper (FICE DP).

The instruments under consideration give rise to claims against the entity that are limited to the entity’s available economic resource, but the claims are also affected by other variables such as a commodity index.

An example of such an instrument is a callable share with a strike price linked to a gold index. All terms of the share are identical to a ‘vanilla’ ordinary share save for the call option. For such a share, the issuer’s obligation is limited to the lower of:

  1. the fair value of the ordinary shares if the option is not exercised (i.e. the claim is limited to the entity’s available economic resources); and
  2. the strike price linked to a gold index if the option is exercised (i.e. the claim is affected by a variable that is independent of the entity’s economic resources).

Under the Gamma approach, a claim will be classified as a liability if it:

  1. requires the transfer of economic resources at a specified time other than at liquidation; or
  2. specifies an amount that is independent of the entity’s available economic resources.

Applying these concepts to the gold-indexed callable share above, the share would be classified as equity in its entirety. This is because the issuer has no contractual obligation to transfer economic resources other than at liquidation and the amount of the claim is limited to, and hence depends on, the entity’s available economic resources. However, once classified as equity, information about the derivative component (i.e. the variability arising from the gold index) will not be disclosed.

In order to address this lack of information, the Staff explored three potential ways to provide useful information.

Staff analysis

1) Accounting for the embedded derivative separately

Under this alternative, the callable share above will be separated into an equity host and an embedded call option derivative, each of which will be separately accounted for. This will lead to a gross up of equity and assets on the statement of financial position (i.e. equity will comprise the cash received on the issue of shares plus the amount of the derivative asset).

The Staff observed that although this alternative captures the entity’s exposure to the embedded derivative through classification, recognition and measurement, there are challenges regarding the identification of the host instrument and separation of the components.

2) Excluding deeply out of the money options from the classification assessment

Under this alternative, deeply out of the money options would be ignored in the classification assessment. For example, a convertible bond with an issuer-held conversion option that is deeply out of the money may be classified as liability in its entirety. This concept may be extended further to all contractual terms that have little or no economic effect. In such a case, the question is whether such contractual terms are substantive and thus relevant for the classification assessment.

Although this might better reflect the economic substance of the financial instrument, the Board’s preliminary view under the Gamma approach is that economic compulsion should not be considered when classifying a claim as liability or equity because this would be inconsistent with the requirement to account for financial instruments based on their contractual terms. The Staff noted further that this alternative will have a far-reaching impact and will affect instruments beyond those under review. Accordingly, they did not recommend that the Board pursue this alternative.

3) Expanding the attribution requirements

Under the Gamma approach, entities are required to provide information for equity-classified derivatives through attributing particular income and expenses to specific classes of equity.

If the Board does not pursue alternatives 1 or 2 above and the entire instrument is classified as equity, the Staff believed that the attribution requirements could be expanded to cover such instruments in order to provide useful information.

Staff recommendation

In light of the above, the Staff recommended that the Board seek feedback from respondents on the following questions before proposing any particular accounting requirements:

  1. a question regarding separation of the embedded derivative; and
  2. whether and how the attribution requirements may help provide information about the alternative settlement features.

Discussion

The Board approved the Staff recommendation.

The Vice-Chair disagreed with the Staff’s analysis of the mandatorily convertible bond example. This features a bond that is mandatorily convertible into a variable number of shares with a cap on the number of shares issuable. The Staff classified the entire instrument as equity. The Vice-Chair believed that it should be classified as a compound instrument with a debt host and an embedded derivative. She reasoned as follows.

Under the Gamma approach, a claim will be classified as a liability if the amount payable is independent of the entity’s available economic resources. A claim will be classified as equity if, inter alia, the amount payable is dependent on the entity’s available economic resources such that the amount never exceeds the available economic resources of the entity. Because the bond is convertible into a variable number of shares, the amount of the claim is independent of the entity’s available economic resources and thus the instrument has a debt host. The dependency should be assessed first before looking at the cap, otherwise this will be subject to structuring opportunities where issuers can include a cap on every instrument to achieve equity classification.

Several Board members were confused about the interaction of the concept of independence (liability classification) and the concept of a claim never exceeding the available resources of the entity (equity classification). They were not sure whether one trumps the other. The Vice-Chair acknowledged these concerns and said it is critical to articulate the interaction of the two concepts clearly in the DP. The Staff will also include the mandatorily convertible bond example above in the DP to assist with the explanation.

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