Financial Instruments Puttable at Fair Value

Date recorded:

Scope of the project

At its March 2005 meeting, the Board agreed to give further consideration to accounting for financial instruments puttable at a pro rata share of the fair value of the residual interest in the issuer ('financial instruments puttable at fair value'). As IAS 32 currently stands, these instruments are classified as financial liabilities. The Board noted that the application of IAS 32 and IAS 39 to financial instruments puttable at fair value, when those shares are the common shares of the entity, gives rise to anomalous accounting.

As a result of the Board's decisions in March 2005, the staff recommended two categories of amendments to IAS 32:

  • 1. The first category encompasses the definition and classification of a 'financial instrument puttable at fair value' and is aimed at shares, partnership interests, and minority interest puttable at fair value. Those classes of instruments have similar features, giving the holder the right to put the instrument back to the entity in exchange for its fair value, which is the instrument's pro rata share of the fair value of the issuer.
  • 2. The second category addresses instruments that have an obligation arising on liquidation. Instruments in limited life entities do not normally contain the right to put the instrument back to the issuer during the life of the entity. Instead, such instruments confer the right to receive cash or other assets on liquidation of the entity, with liquidation being a certain event. Put another way, shares in limited life entities establish an obligation that arises on liquidation, and liquidation will occur at a known date.

The amendments would result in all of the following being classified and presented as equity: shares, partnership interests, and minority interests puttable at fair value, and shares in limited life entities.

For discussion purposes, the issues were analysed as follows:

  • 1. Instruments puttable at fair value.
  • 2. Instruments with obligations arising on liquidation, and liquidation is certain (affects limited life entities).
  • 3. Instruments with obligations arising on liquidation, and liquidation is at the option of the holder (affects partnership interests).
  • 4. Classification of minority interests in consolidated financial statements, when minority interests are puttable at fair value or an obligation arises on liquidation (and liquidation is certain or at the option of the holder).

The Board decided to tackle issue 1 first, to set the guidelines from which the more complex issues down the list could be addressed. The Board discussed the staff's proposals at length, noting that whether the put option is a separate instrument from the shares should not result in different accounting. If this is not achieved, the result would be the creation of structuring opportunities.

The Board agreed that the only short-term solution to this issue would be to create exceptions until the long-term project dealing with equity and liabilities has been completed. This exception would specify that it would only be available for all of the equity that is the subject of the put option (that is, there would be no opportunity for other types of contracts to be written over similar equity instruments). In addition, that class of equity must be the 'absolute residual' - the 'most subordinated' class of equity. Additional work would be performed to adequately ring-fence these exceptions.

The Board discussed what would constitute different classes of equity (for example, where different voting or participation rights attach to the same category of shares) but did not make decisions on this issue. The Board seemed to agree that in the consolidated financial statements, a non-controlling interest (minority interest) would be considered to be the same class of equity to that of the parent entity (that is, the existence of a non-controlling interest would not disqualify an entity from applying the exception).

Items 2 through 4 above were not addressed as distinct issues but were referred to at various points throughout the Board's discussions.

The Board noted the reservations of some members about the additional complexity that would be introduced into the accounting for financial instruments if these proposals are adopted. The Board agreed to proceed with this project, as it has already been taken onto the agenda and because the issue is significant.

Determining whether a share puttable at the fair value of the residual interest in the entity should be split into an ordinary share and a put option with approximately zero value

On this issue, the staff recommended the following:

A compound financial instrument should be split into components when it is clear that the components exist, that the components can be separated and when separating the components results in faithful representation of the financial position of the entity. In the case of the put option in a puttable share, the staff found that it was not possible to separate a component as it was not possible to economically identify those situations in which the put option would be exercised. In addition the put option component is not identifiable based on separate cash flows.

The staff also found that shares puttable at a fixed strike price are economically similar to convertible debt. Consequently the staff believes that classifying a puttable share as equity while classifying convertible debt principally as liability does not result in the faithful representation of what are economically similar obligations. In other words, the put option changes the nature but not necessarily the value of the obligation to shareholders.

Consequently, the staff did not recommend that a puttable share be split into an ordinary share and put option with a floating strike price.

Some Board members indicated support for the staff recommendation and others for an alternative approach that acknowledges that IAS 32's classification scheme is 'fundamentally flawed'. Supporters of the alternatives conclude that the composite instrument described as a puttable share does not satisfy the definition of a liability, and presenting it as a liability does not enhance the relevance of the financial statements. Proponents of this view acknowledge that there is a liability component of the instrument, but measuring that liability based on redemption amount described in IAS 32 is not the fair value of that component on initial recognition. Such measurement is inconsistent with how virtually all other financial instruments and mostg non-financial liabilities are measured (excepting, perhaps, employee benefit obligations).

The Board was asked to vote on whether (a) to continue a separate project on financial instruments puttable at fair value or (b) to address the issue in the broader and longer-term liabilities and equity project. The Board agreed to add this issue to the broader liabilities and equity project whilst continuing with the separate project on financial instruments puttable at fair value.

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