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Financial instruments with characteristics of equity

Date recorded:

Summary of feedback — Cover paper (AP 5)

In June 2018 the Board published the Discussion Paper Financial Instruments with Characteristics of Equity (DP) for comment by January 2019. The Board received 128 comment letters.

At this meeting the staff will provide a detailed summary of the feedback received on sections 2 to 5 of the DP as well as the puttable exception and IFRIC 2 instruments. The Board are not being asked to make any decisions.

Summary of feedback ― The Board’s preferred approach (AP 5A)

Background

The Board’s preferred approach to classification, described in the DP, would classify a claim as a liability if it contains:

  • An unavoidable obligation to transfer economic resources at a specified time other than at liquidation (the timing feature); and/or
  • An unavoidable obligation for an amount independent of the entity’s available economic resources (the amount feature).

The paper provides more background about the treatment proposed by the DP.

Key messages

The key messages from the feedback received on the Board’s preferred approach are the following:

  • Should the Board retain the binary classification in its preferred approach? Most respondents supported the binary distinction between liabilities and equity.
  • What features of claims are relevant in distinguishing financial liabilities from equity? Most respondents agreed that both the timing of the required transfer of economic resources and the amount of the obligation are the relevant features for the purpose of distinguishing financial liabilities from equity. However, most respondents were not supportive of the amount feature assessment as described in the Board’s preferred approach.
  • Should classification be driven by any other features of claims? Most respondents agreed that information about other features of claims, such as priority of claims, should be provided through presentation and disclosure.
  • Do respondents support the use of timing and amount features in classifying financial instruments as proposed in the DP? Almost all respondents expressed support for the timing feature. Note that many respondents, primarily from the banking sector, questioned how to interpret the term ‘liquidation’ as included in the timing feature.

    Most respondents disagreed and/or expressed concerns over the amount feature assessment, in particular, how it applies to obligations for an amount payable only on liquidation. Respondents also highlighted a number of challenges associated with the new terminology used to articulate the amount feature such as the dependency on the entity’s available economic resources. Some respondents acknowledged the inherent difficulty in defining ‘residual interest’.

Specific areas of feedback on the Board’s preferred approach are analysed in the staff paper categorised by subject. The staff paper also includes suggested classification approaches alternative to the Board’s preferred approach.

Board discussion

Agenda Papers 5A to 5C were discussed together.

The Board members acknowledged the concerns raised from respondents. They concluded that respondents were generally supportive of a conceptual solution, but some of the comment letters indicated that the issue could not be solved without some specific rules. One Board member made a strong point for beginning with the definition of a liability in the Conceptual Framework and develop the principles for classification from there. Conceptual soundness was vital as the financial instruments industry could otherwise develop new products to circumvent the requirements.

On the liquidation issue, the Vice-Chair asserted that respondents were contradicting themselves by saying ‘at liquidation’ does not work in a going concern scenario, while they agreed with instruments being classified as equity as payment would only occur on liquidation. As regards the fixed-for-fixed condition, the Board now understands fully how this condition is applied in practice and what should be undertaken to improve the outcome. She also said that it was interesting to see that the foreign currency denominated equity was a concern.

As regards the binary classification, one Board member said that this provides useful information, but only if it is conceptually sound and fully understood by preparers. The Board would have to overcome many issues to achieve this. If this cannot be achieved, the Board would have to think about a non-binary classification system.

One Board member asked whether the staff were envisioning a new Standard or an update to IAS 32. The staff replied that this decision will be made at a later Board meeting after having discussed all the issues raised by respondents.

No decisions were made.

Summary of feedback ―  Classification of non-derivative financial instruments (AP 5B)

Background

The DP states the following in paragraph 3.10: 

A non-derivative financial instrument may contain more than one possible settlement outcome that might depend on future events, or on the holder or issuer exercising rights […]. If an entity does not have the unconditional contractual right to avoid a settlement outcome that has one or both of the features of a financial liability […], then the entity identifies that unavoidable obligation first and classifies that obligation as a non-derivative financial liability. If the non-derivative financial instrument also contains another possible settlement outcome that does not have the feature(s) of a financial liability […], then the entity considers whether the instrument is a compound instrument […].

Key messages

The key messages from the feedback received on classification of non-derivative financial instruments are the following:

  • Do respondents agree with the Board’s preferred approach to classification? Almost all respondents agreed with the timing feature of the Board’s preferred approach. Most respondents agree that both the timing of the required transfer of economic resources and the amount of the obligation are the relevant to distinguishing financial liabilities from equity. However, most respondents were not supportive of the amount feature assessment as described in the Board’s preferred approach.
  • Are the proposals in the DP leading to many changes in classification of non-derivative financial instruments? Many respondents highlighted that applying the amount feature of the Board’s preferred approach leads to classification changes from equity to financial liabilities for particular types of non-derivative financial instruments. Particularly, financial instruments that contain an obligation for an amount independent of the entity’s available economic resources that arises only at liquidation or that can be deferred at the issuer’s discretion until liquidation, a feature common in many Additional Tier 1 (AT1) instruments issued by banks and perpetual bonds issued by corporates. Many respondents including investors and issuers of such instruments expressed concerns that these classification changes may lead to market disruption, some disagreed with the liability classification while others did not welcome any change in classification of financial instruments that in their view are well understood. Some also highlighted application challenges that would arise from classifying these instruments (wholly or partly) as a financial liability.

Specific areas of feedback on classification of non-derivative financial instruments are analysed in the staff paper categorised by type of instrument (irredeemable financial instruments with non-cumulative coupons, convertible instruments issued in a foreign currency and irredeemable cumulative financial instruments).

Most respondents who provided feedback about specific classification changes consider that the changes from equity to financial liabilities would have a significant impact in a wide range of industries. To mitigate the impact, these respondents urged the Board to consider:

  • (a) performing a comprehensive impact assessment to fully take into consideration the effects and underlying costs of implementing these proposals; and
  • (b) providing a phase-in period of several years (i.e. allow several years before the change in classification takes effect for existing financial instruments) or allow grandfathering of existing financial instruments, in order to ensure a smooth transition.

Summary of feedback ― Classification of derivative financial instruments (AP 5C)

Background

The Board’s preferred approach for classifying derivatives on own equity—other than derivatives that include an obligation to extinguish an entity’s own equity instruments—is as follows:

  • (a) a derivative on own equity would be classified in its entirety as an equity instrument, a financial asset or a financial liability—the individual legs of the exchange would not be separately classified; and
  • (b) a derivative on own equity is classified as a financial asset or a financial liability if:
    • (i) it is net-cash settled—the derivative could require the entity to transfer cash or another financial asset, and/or contains a right to receive cash for the net amount, at a specified time other than at liquidation (the timing feature); and/or
    • (ii) the net amount of the derivative is affected by a variable that is independent of the entity’s available economic resources (the amount feature).

Key messages

The key messages from the feedback received on classification of derivative financial instruments are the following:

  • Do respondents agree with the challenges set out in the DP on classifying derivatives on own equity? Most respondents agreed with the challenges identified, noting that a vast majority of practice challenges with IAS 32 Financial Instruments: Presentation relate to classification of derivatives on own equity, more specifically, the application of the fixed for-fixed condition in IAS 32 is particularly challenging.
  • Should derivatives on own equity be classified in their entirety? Almost all respondents, supported the proposal for a derivative on own equity to be classified in its entirety.
  • Should derivatives on own equity be classified as equity instruments, financial assets or financial liabilities? Many agreed that derivatives on own equity should be classified as equity instruments, financial assets or financial liabilities. However, few respondents expressed the view that derivative instruments should not be classified as equity because they think that the future delivery or receipt of own equity should not be considered as part of an entity’s equity prior to the actual delivery or receipt of the equity instruments.
  • Do respondents support the application of the timing and amount features to classification of derivatives on own equity? Many respondents were not supportive of the Board’s preferred approach to classification of derivatives on own equity, due to the concerns arising from the application of the amount feature. However, some of these respondents consider that several existing application challenges with the fixed-for-fixed condition in IAS 32 would be addressed if the Board further develops some of the proposals described in the DP.

Specific areas of feedback on classification of derivative financial instruments are analysed in the staff paper categorised by subject. The staff paper also includes suggested alternative classification approaches.

Summary of feedback ― compound instruments and redemption obligation arrangements (AP 5D)

Background

In this paper the staff summarise the detailed feedback received on Section 5 of the DP, which discusses compound instruments (contracts that include both a liability and an equity component, e.g. convertible bonds and puttable shares) and redemption obligation arrangements (arrangements that contain a non-derivative equity instrument and a standalone derivative to extinguish that equity instrument, e.g. own shares and a written put option on own shares). The paper provides more background with regards to the treatment proposed by the DP and reproduces the questions asked for this topic.

Key messages

The key messages from the feedback received on compound instruments and redemption obligation arrangements are the following:

  • Generally, respondents acknowledged diversity in the current accounting practice and welcomed the efforts to address the accounting for compound instruments and in particular written put options on non-controlling interests (NCI puts) and the Board’s attempts to minimise divergence in practice. A few respondents noted however that the preferred approach for compound instruments and redemption obligation arrangements seems to be overly complex.
  • Most respondents to Question 6 of the DP focussed on the requirements proposed for redemption obligation arrangements and in particular, NCI puts, rather than discussing proposals for compound instruments in general.
  • Respondents expressed mixed views on the proposed accounting for redemption obligation arrangements (including NCI puts). This was largely based on whether or not respondents believed own shares and a written put option on own shares was fundamentally and economically different from a convertible bond. Most respondents expressed concerns about proposed derecognition of own shares, particularly when they represent NCI, and the potential impacts on the consolidated financial statements. In this regard, many respondents highlighted or raised questions on the impact of the DP’s proposals on other IFRS Standards such as IFRS 10, IFRS 3 and IAS 33.
  • In their response to the questions related to financial instruments with alternative settlement outcomes controlled by the entity, many respondents agreed with some parts of the proposals in the DP while they disagreed with other parts. Most respondents to these questions agreed that the Board should address the issue and most of them were in favour of the Board addressing the issue through additional disclosures. Some respondents suggested alternative approaches to classifying these instruments that would take into consideration the impact of economic compulsion and indirect obligations.

Specific areas of feedback on compound instruments and redemption obligation arrangements are analysed in the staff paper categorised by subject.

Board discussion

There was not much discussion on this paper. The Vice-Chair concluded that respondents generally agreed with the Board’s approach in the DP. On derecognition, she would like to think through what the ‘Day 2’ accounting would look like in different scenarios.

One Board member said that the timing and amount feature were supposed to take the pressure off the concept of economic compulsion, however, if the Board were to abandon part of those features, economic compulsion would become more important again.

No decisions were made.

Summary of feedback ― puttable exception and IFRIC 2 instruments (AP 5E)

Background

In this paper the staff summarise the detailed feedback received on Question 4 of the DP which deals with the puttable exception in IAS 32, as well as the feedback received on instruments in the scope of IFRIC 2. The paper provides more background with regards to the treatment proposed by the DP and reproduces the questions asked for this topic.

Key messages

The key messages from the feedback received on puttable exception and IFRIC 2 instruments are the following:

  • Most of the respondents to Question 4 in the DP agreed with retaining the puttable exception. However, some respondents disagreed with the proposal and suggested some alternative approaches that would overcome the need for the puttable exception.
  • Some respondents that agreed with retaining the puttable exception highlighted application issues arising in practice for example, relating to identifying the most subordinated instrument or determining whether puttable instruments have identical features and recommended the Board provides guidance to address these application challenges. A few respondents that disagreed with retaining the puttable exception suggested the Board undertake further work to establish the extent to which the puttable exception is used in practice, the application challenges arising from it and whether potential improvements to IAS 32: 16A-16D could be identified before deciding whether to retain the exception.
  • Some respondents considered the impact of the puttable exception on classification of financial assets in IFRS 9 Financial Instruments from the holder’s perspective and encouraged the Board to assess whether the classification criteria from the holder’s perspective should be the same as from the issuer’s perspective.
  • Almost all the respondents that commented on the classification of IFRIC 2 instruments strongly supported the requirements in IFRIC 2 being carried forward and believed that co-operative shares that meet the IFRIC 2 conditions and represent the most subordinated claim should be classified as equity under any classification approach.
  • Some respondents were concerned that the Board’s proposals with respect to the amount feature would affect the equity classification outcome of IFRIC 2 instruments.

Specific areas of feedback on puttable exception and IFRIC 2 instruments are analysed in the staff paper.

Board discussion

There was no discussion for this agenda paper. No decisions were made.

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