Financial instruments settled in own equity instruments: foundation principle (Agenda Paper 5A)

At the December 2019 Board meeting, the Board discussed the staff’s preliminary analysis on how the fixed-for-fixed requirement in IAS 32 could be clarified. Based on the input provided by Board members at that meeting, the staff have developed their analysis further and asks the Board to make tentative decisions that will help set the direction for the clarified principles that are being developed (Agenda Paper 5B).

In the papers, the staff analyse the classification of derivatives on own equity, whether standalone or embedded in a non-derivative instrument.

In December 2019, the Board considered the following potential clarifications proposed by the staff to explain the rationale for the fixed-for-fixed condition in IAS 32:16:

1. Foundation principle—a derivative on own equity that meets the fixed-for-fixed condition should have a fair value on the settlement date (settlement value) that is:
   • a) only affected by fluctuations in the price of the underlying equity instruments (exposed to equity price risk); and
   • b) not affected by fluctuations in other variables that the holder of the underlying equity instruments would not be exposed to (not exposed to other risks).
2. Adjustment principle—if a derivative is subject to any adjustments to the amount of cash or another financial asset, or the number of own equity instruments, the adjustments would not preclude the derivative from meeting the fixed-for-fixed condition if the adjustments:
   • a) preserve the relative economic interests of the derivative holder and the underlying equity instrument holder (‘preservation adjustments’); or
   • b) compensate the issuer for the fact that the derivative will be settled at a future date (‘passage of time adjustments’).

This paper sets out an analysis of the “foundation principle”—including its application to some illustrative examples—and includes two alternative methods of articulating the foundation principle: “Alternative A” is a direct refinement of the foundation principle discussed in December 2019, whereas “Alternative B” articulates the foundation principle based on the certainty of the amount of cash exchanged per unit of equity instrument.

The paper also discusses the classification of share-for-share exchanges, where contracts are settled by the issuer exchanging one type of its own non-derivative equity instruments for another type of its own non-derivative equity instruments. The paper notes that IAS 32 does not address a fact pattern that involves a share-for-share exchange where both legs of the exchange are a fixed number of own shares. The staff are aware that different views exist in practice with respect to how such a contract should be classified.

Summary of the staff’s preliminary views

Foundation principle—The staff’s preference on how to articulate the foundation principle necessary to assess the fixed-for-fixed condition is “Alternative B” because of the potential limitations of “Alternative A” discussed in this paper. Also, Alternative B does not use new concepts such as settlement value, which should make it easier for stakeholders to understand and implement. Foundation principle Alternative B is articulated as follows:

In a derivative on own equity that meets the fixed-for-fixed condition, the amount of functional currency units to be exchanged with each underlying equity instrument is fixed and does not vary other than (if applicable) with:

• i) preservation adjustments; and
• ii) passage of time adjustments.

Share-for-share exchange—The staff’s view is that a contract that will or may be settled by exchanging a fixed number of non-derivative own equity instruments with a fixed number of another type of non-derivative own equity instruments should be classified as equity. By issuing such a contract, the issuer will be or may be extinguishing one type of own equity with another type of own equity. The value of shares received in exchange may be different from the value of shares delivered. However, such a contract would not impose any additional obligations on, or give any additional rights to, the issuer compared to a scenario in which it issues and reacquires the underlying equity instruments directly.

Questions for the Board

1. Foundation principle for classifying derivatives on own equity - does the Board agree that Alternative B is a better way of articulating the foundation principle?
2. Share-for-share exchange - if the Board agrees with Alternative B for articulating the foundation principle, does the Board agree with the staff’s analysis of the share-for-share exchanges where both legs of the exchange are a fixed number of non-derivative equity instruments of the entity?

Discussion and voting

One Board member questioned whether an additional example using a variable interest rate (a variation in the amount that would be converted) would clarify that provided there is a fixed conversion ratio, an equity classification is still achieved. The staff said that the focus is on the fixed exchange ratio, therefore both a variable or fixed interest rate would be covered.

Another Board member asked if a subsidiary issued an underlying equity instrument within the Group, based on paragraph 8(c), should the Group be seen as the issuer? The staff said that if a subsidiary issues a derivative over its own equity, then the subsidiary will be the issuer. If another Group entity issues a derivative over that subsidiary’s shares, then the Group will be the issuer.

Further questions were raised regarding which functional currency to use (assuming these differ across group entities) depending on which entity had issued instruments and which entity’s shares are being delivered (i.e. the parent or a subsidiary). The staff clarified that the functional currency of the entity issuing the underlying equity instrument would be used.

Another Board member sought clarification regarding when the paper refers to an amount being fixed and whether this is the book value rather than the fair value of an instrument. Fair value could be affected, for example, by fluctuations in interest rates. The staff said that they don’t mean the fair value, they mean the fixed unit of functional currency, be it the principal or accrued interest – in other words the notional amount, which would be close to book value. Another Board member pointed out that it’s the amount due under e.g. the bond – it’s nothing to do with accounting carrying amounts. Further, the articulation should be tested against a convertible bond with a range of possibilities, including settlement of different liabilities. The staff agreed and noted that they’ll be clear on that.

Another Board member suggested that the ‘Foundation principle’ is not actually a “principle”, but rather a better articulation of the fixed-for-fixed condition already established in IAS 32 (which was difficult to understand), and that maybe they should use another term.

Another Board member supports Alternative B, noting that application of Alternative B to preservation and passage of time adjustments examples in Agenda Paper 5B worked better than Alternative A. Similarly, another noted that it’s a lot easier looking at exchange ratio at initial recognition, than looking at the value at the settlement date.

Another Board member noted their support for alternative B, considering that if they look at paragraph 30 as a preparer, it would be clear to them what needs to be done. They noted that paragraph 30’s beauty is its simplicity: “if the issuer does not know how many functional currency units it is entitled (or obligated) to exchange per equity instrument, the derivative would not qualify for equity classification” – that is evergreen and will last a long time as new products emerge.

The vote was held on question 1 with staff agreeing to relook at the term ‘principle’. 13 Board members voted in favour of the staff’s recommendation with 1 absent.

The vote was then held on question 2, regarding the share-for-share exchange. 13 Board members voted in favour with 1 absent.

Financial instruments settled in own equity instruments: adjustment principle (Agenda Paper 5B)

In December 2019, the Board discussed developing a principle to allow the following two types of adjustments to derivatives on own equity to meet the fixed-for-fixed condition:

• a) Preservation adjustments—these adjustments preserve the relative economic interests of the potential or future equity instrument holder (in the case of options or forwards respectively) and the existing underlying equity instrument holder.
• b) Passage of time adjustments—these adjustments compensate either the issuer or the holder of a derivative for changes in the timing of exercise of a derivative or changes in the exercise date of the option. The passage of time adjustment must vary with the passage of time, i.e. the timing of settlement of the derivative.

Within the paper, the staff present two alternatives (Alternatives A and B) to describe the preservation adjustments that would be allowed in an equity-classified derivative, and four alternatives ways (Alternatives A – D) to specify what is an allowable passage of time adjustment in order to classify a derivative as equity.

Summary of the staff’s preliminary views

The staff’s preliminary views on how to articulate the adjustment principles necessary to assess the fixed-for-fixed condition are set out below.

• a) Adjustment principle: Preservation adjustments—The staff prefer Alternative B. Applying Alternative B, preservation adjustments would not preclude equity classification of derivatives on own equity if they require the issuer to preserve the relative economic interests of the potential or future shareholders to an equal or a lesser extent than the underlying equity instrument holders.
• b) Adjustment principle: Passage of time adjustments—The staff prefer Alternative B. Applying Alternative B, passage of time adjustments would not preclude equity classification of derivatives on own equity if they:
  • a. are pre-determined and only vary with passage of time; and
  • b. have the effect of fixing the number of functional currency units per underlying equity instrument in terms of a present value.

Questions for the Board

1. Preservation adjustments—does the Board agree that Alternative B should be used to articulate allowable preservation adjustments?
2. Passage of time adjustments—does the Board agree that Alternative B should be used to determine what is an allowable adjustment for the passage of time?

Discussion

Preservation adjustments

A Board member sought clarification that if there is no preservation adjustment, it is difficult to see whether or not the nature of the transaction is fair towards everyone. For example, if a particular exchange rate is locked in, but subsequently a dilution event occurs which is not reflected in the agreement. That event would be disadvantageous to the holder of the equity instrument, but it would be ignored as there is no preservation adjustment. The staff confirmed that it would meet “fixed-for-fixed” nonetheless, because there are no adjustments to the exchange ratio in that contract. The Board member noted that it seems to suggest that preservation is not in itself a principle, but a test of what should happen in the circumstance of a preservation adjustment. This supported Alternative B, as there is no adjustment in place that would cause harm to the existing shareholders.

Board members who supported Alternative B said:

• when a preservation adjustment is equal (alternative A), a plain vanilla option would not satisfy this departure rule and would create a discrepancy or a gap.
• the preservation adjustment and the passage of time adjustment would grant some relief from a really strict application of the principle (and they should explain that it is not a practical expedient).

The vote on Question 1 was 13/14 in favour of alternative B, 1 absent.

Passage of time adjustments

Board member comments included:

• The objective followed the logic in IAS 32, but explained it better as IAS 32 currently only has fixed-for-fixed and that they would be happy with either Alternative A or Alternative B. They would not get into the complexity of C and D – as they don’t believe they had designed “fixed-for-fixed” as a very sophisticated concept. Read literally, IAS 32 only allows for pure “fixed-for-fixed”, so this exercise is softening those lines and the Board should remember that.
• Tending towards Alternative C, and seeing this as a relaxation of the strict fixed-for-fixed principle. They would like somebody to have to say “yes that’s reasonable for the passage of time” but would not add guidance on what its reasonable. They think of C as adding to B, i.e. “… and that compensation has to be reasonable”. The additional hurdle is not very high, but should not open the door to things that would otherwise have failed B. Another Board member challenged this, asking what investment bankers are going to think is reasonable based on an option pricing model. For a one-year option vs a three year option, it is not going to be just “is that an appropriate discount rate”? It is about equity volatility. The passage of time is a complicated concept in option pricing. The staff said that Alternative C builds on A, and that the risk of structuring might be limited compared to Alternative D. However the question about what is “reasonable”, and the diversity of opinion, will be there - so that problem will still exist in Alternative C. That could lead to diversity and more interpretation-type questions. What is considered reasonable in one jurisdiction might not be reasonable in another (e.g. comparing a high versus low interest rate jurisdictions). C and D require assessing what is “reasonable” in each context, otherwise there will be as many interpretations / diversity in practice questions as we have currently.
• What an investment banker thinks is reasonable on a structured equity derivative could be interesting—they discounted D and was not keen on C. Part of what they are trying to do is take away the exercise of judgement to arrive at a structured product that fits the needs/desires of people. Building in “reasonable” means that they get people with different opinions about what fits and what doesn’t fit. Because the goal is to clarify and reduce diversity, they don’t like “reasonable” and would favour Alternative B.
• Under Alternative B, you’re required to determine the present value, which should be the same for each of the successive dates going into the future. They suggested that some see C as being a mechanism for controlling the selection of the over the interest rate, which is why they see it as being additive to B. The Board member believes that C is set up with regards to an adjustment that was predetermined but it didn’t have to be based on a present value type of principle, it just needed to be reasonable. For example, if you assume the share price would go up and then later go down, it would be reasonable then for the strike price to go up and then go down. That Board member said it means that Alternative B leaves open how the interest rate applied to get to the present value, would be determined. The staff agreed. The Board member summarised, noting that it’s just a matter of, “you use a discount rate and as long as that discount rate tracks to the strike price over time”. They support the staff recommendation of B.
• Thinking about whether to support Alternative C because of the need for a “reasonable” passage of time adjustment, the member noted that it is already implicit in B through the name of the adjustment – it is a passage of time adjustment, and nothing else should be included.
• Countries with high inflation and high interest rates, sometimes an adjusted strike price indexed to an inflation index or benchmark interest rate is in substance compensation for the time value of money, and not to leverage the transaction. However under the staff proposal, it would not qualify as an equity instrument under Alternatives A, B or C. They considered that Alternative D would be reasonable in this type of situation but acknowledged the challenges with this alternative.
• Plain vanilla options should not be liabilities. Variations of plain vanilla options could be liabilities, such as when they contain a “down-round” feature. However, if the down-round feature only contributed 5% to the price of the total instrument 95% of the price option is attributable to the plain vanilla option, which is equity.
• Prefers Alternatives A and B. Would be nervous to use the word “reasonable” in the Standard, because what is reasonable or not is dependent on the individual making the assessment.
• Preferring Alternative A, but the scenarios where there is much more on top of additional exercise dates, the explanation for the analysis included in Alternative B seemed more helpful to understand where to draw the line.
• Although comfortable with Alternative A and Alternative B, they prefer B—the key being how to determine the discount rate. The member asked whether the concept is that the discount rate should represent compensation for the passage of time, and not consider other factors.

The vote was held on Question 2 – with 10/14 in favour of Alternative B, 1 absent.