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Financial instruments with characteristics of equity

Date recorded:

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” is an alternative way to articulate 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?

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:

  • 1. 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.
  • 2. 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?

Disclosures: Planned outreach (Agenda Paper 5C)

The purpose of this paper is to set out the staff’s plan for outreach with stakeholders on potential disclosures that can be developed as part of the FICE project. In this paper the staff recap some of the concerns raised and suggestions made by stakeholders for each type of disclosure that was proposed in the 2018 Discussion Paper Financial Instruments with Characteristics of Equity (2018 DP). The staff then present potential refinements for each type of disclosure that could address some of these concerns and suggestions. The potential disclosure refinements will be used to help facilitate the discussions during the outreach with stakeholders.

For each type of disclosure, the following is discussed:

  • i) 2018 DP proposal;
  • ii) Challenges and concerns raised in the 2018 DP feedback; and
  • iii) Potential disclosure refinements.

Question for the Board

The staff are not asking the Board to make any decisions at this meeting but would welcome any comments or questions on the staff’s outreach plan.

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