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IAS 32 — Classification of mandatorily convertible instruments with an issuer option to convert into the maximum fixed number of shares

Date recorded:

The Committee received two requests to address the accounting for a financial instrument that is mandatorily convertible into a variable number of the issuer’s own shares (subject to a cap and a floor on the number of shares to be delivered) but gives the issuer the contractual right to settle the instrument at any point before maturity by delivering the maximum number of shares (fixed and capped). The submissions asked how the issuer of such an instrument should classify it in accordance with IAS 32 Financial Instruments: Presentation. Specifically, the submissions focused on the issuer’s option to settle the instrument before maturity by delivering the maximum number of its own shares—and asked how that particular feature should be assessed for the purposes of applying the definitions of a financial liability and an equity instrument in IAS 32.

The key features of the instruments are:

  • They have a stated maturity date,
  • There is a cap and floor to the instrument therefore the holder of the instrument is not subject to equity price risk,
  • When the instrument is issued, the fair value of the issuer’s equity share would equate to the delivery of a number of shares that is within the range between the cap and the floor,
  • The issuer is required to make fixed interest payments on the instrument (the first case required payment to be made annually whereas in the case of the second, payments could be deferred but they must be paid before the instrument settled),
  • The issuer has the contractual right to settle the instrument at any time before maturity (but if it chooses to do so it must deliver the maximum number of shares and pay in cash all of the interest payable up to maturity, which is computed as the present value of the interest that would be payable),
  • The instruments have short lives but do not specify the term of the instrument.

The submission focused on the issuer’s early settlement right and how it should be treated under IAS 32 and if it affects the classification of the instrument (i.e. liability vs. equity).

Staff focused various items when assessing this with substance being the key, i.e. whether the issuer’s early settlement option has substance as the guidance in the standards requires the issuer of a financial instrument to classify the instrument in accordance with substance of contractual agreement, which will significantly determine the instrument’s accounting. IAS 32 does not require or permit the contractual arrangement to be taken into consideration when classifying a financial instrument. In addition, staff noted judgement will be required which will depend on the following items in relation to the instrument:

  1. Term of the agreement;
  2. Width of the cap and floor;
  3. The share price and the volatility of the share price; and
  4. The real economic and business reasons for exercising the option.

Staff noted that the Committee discussed a submission in March 2006 for a possible agenda item relating to the role of a contractual obligation and economic compulsion in the classification of financial instruments. Economic compulsion is not relevant to the instrument described, instead the focus should be on the contractual rights and obligations on each component of the instrument to see if has substance or not. Staff recommended no further guidance was required in this case. As a result the interpretations criteria was not met and hence this should not be taken onto the Committee’s agenda and tentative agenda discussion was proposed.

A Committee member highlighted that Staff’s paper focused on the instrument not having substance which will not always be the case as there may be business reasons along with economic ones for entering into such an arrangement. Another member raised the issue that Staff had concluded that the facts were not genuine under AG28 of IAS 32 which is in contrast with the views presented and therefore staff should address the issue by defining the type of instrument i.e. liability or not to start with and then address the substance.

Staff explained that IAS 32 has clear signposts, where if an entity has an unavoidable obligation to make payment of for example equity instruments, then it has a liability and if the payment is at the entity’s discretion it is not a liability. This was the logic and distinction used when addressing this issue and the previous issue where it was determined that was a liability.

A Committee member agreed with some of Staff’s conclusions in that judgement is required to determine whether the issuer’s early settlement option is substantive and the issuer should consider real economic or business reasons for exercising the option. However, the member disagreed with staff’s conclusion that the issuer’s contractual right to settle the instrument at any point in time before maturity by delivering the maximum number of shares is unlikely to have substance. The member highlighted that “sufficient benefit” is not a requirement within IAS 32 and therefore would be introducing a new concept.

The Committee approved the tentative agenda decision based wording that judgement will be required to determine whether the issuer’s early settlement option is substantive. The paper also should not be specific to the instruments in question and should give an overview of similar products which may have substance. Staff were requested to remove the paragraph relating to the unlikelihood of the issuer’s contractual right to settle the instrument at any point before maturity by delivery of the maximum number of shares as being substantive. Committee members suggested referring to paragraph 20(b) of IAS 32 when considering if the option has indeed commercial substance and consequently rewording the agenda decision. The Committee agreed to publish the agenda decision by the end of July so the project is finalised by November.

With regards to paragraph seven of the staff paper, there was general agreement that it is important to consider the basic instrument in trying to make an assessment of whether an instrument is an equity instrument or a liability instrument and therefore it should be considered.

In addition, the Committee agreed to bring the issue regarding simple instruments as discussed in the Staff’s paragraph 7 back to the next Committee meeting.

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