Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation

Date recorded:

The Board re-examined the characteristics that result in puttable instruments being considered as the residual interest, i.e. to qualify for equity classification.

The Exposure Draft Financial Instruments Puttable at Fair Value and Obligations arising on Liquidation (ED) identified the residual interest in the net assets of an entity by requiring all individual puttable instruments

  • a) to be in the most subordinate class of instrument,
  • b) to be issued and puttable at the fair value of the pro-rata share of the net assets of the entity, and
  • c) to have neither a limited nor guaranteed return.

With regard to requirement b) above the Board tentatively agreed that the full participation in the performance of the issuer can be best demonstrated when the instruments are issued and puttable at the fair value of the instruments.

Some constituents noted that, in particular, requirement b) makes the scope of the proposed amendment too narrow.


The 'Revised Approach'

In response to these comments the staff presented the Revised Approach. The main feature of this approach is that the class of puttable instruments as a whole is required to represent the residual interest in the entity. Accordingly, the put price of the individual instrument would be of little relevance for classification of the class of puttable instruments as long as the class as a whole represents the residual interest in the entity. However, all individual instruments still need to be equal in all other respects.

The Revised Approach eliminates requirement b) and, accordingly, the definition of residual interest much more relies on requirement c) above.

The staff proposed that the ED should be modified to describe what type of return is characteristic of equity rather than only stating what type of return does not qualify for equity classification. The following amendment was proposed:

'The total return of the puttable instrument is based substantially on the net earnings or the change in net assets of the entity (excluding any possible effect the puttable instrument may have on net earnings or net assets). An example of a puttable instrument with a return that is not based substantially on the net earnings or the change in net assets of the entity is a puttable instrument that has a fixed or guaranteed total return to any extent, before or at liquidation'.

The staff drew to the attention of the Board that the definition of returns does not address the issue that there might other (less subordinated) instruments that are absorbing most of the variability in the performance of the entity and leaving only a predetermined (but slightly variable) amount of net earnings or net assets for the class of puttable instruments. To address this potential flaw the staff suggested including the following guidance in the ED:

'The variability of the total return to the class of puttable instruments is not substantially absorbed by another contract or financial instrument, or some combination thereof. If a determination cannot be made that these conditions are met, the puttable instruments are classified as liabilities.

Ordinary commercial contracts, like leases, mortgages, and franchise and license agreements may include provisions based on elements of the entity's performance (for example, a percentage of gross revenue). Contracts entered into on normal commercial terms with unrelated parties are unlikely to fall within the meaning of this test. For example, if commercial practice for lessors is to base rentals in part on a percentage of gross sales, and the percentage in the entity's lease is consistent with amounts charged in the are area, then the lease should not be considered to absorb substantial variability in net earnings or net assets.'

The Board agreed to proceed with the Revised Approach.


Mandatory dividends and partnership remuneration

The staff suggested that the ED should not provide guidance as to whether a mandatory dividend is a contractual obligation.

The Board agreed to this by majority vote but pointed out that the following principle should be clarified in the ED:

  • If a mandatory dividend is required to be paid in the absence of profit the instrument does not qualify as equity classification.
  • If a mandatory dividend is requried to be paid only if sufficient profit is available such a clause should not prevent the instrument from being classified as equity.

Derivatives on puttable instruments and limited life obligations The Board unanimously decided to retain the guidance in the ED that derivatives on puttable instruments or limited life entity shares are not equity.

Reclassification of instruments

The Board decided to include the following guidance on how to reclassify an instrument under the ED:

  • On reclassification from liability to equity the instrument is classified as equity with a carrying value equal to its previous carrying value. There should be no gain or loss.
  • On reclassification from equity to liability the equity instrument will be carried at cost while IAS 39 Financial Instruments: Recognition and Measurement requires initial recognition of a liability to be at fair value (paragraph 43). Any difference between the carrying value of the equity instrument and the fair value of the newly recognised financial liability should be recognised in equity.


Mandatory redemption

The staff noted that the ED does not address this issue explicitly but that the criteria in the ED (also under the Revised Approach) would not prohibit an instrument in which the embedded put is automatically exercised on the occurrence of specific certain or uncertain events (such as death or retirement) from being classified as equity.

There seemed to be a consensus that mandatory redemption on death or retirement does not prohibit an instrument from being classified as equity. One Board member noted that such clauses have been used for decades and that any change to this principle would have massive implications for many instruments currently classified as equity under IFRSs, i.e. would go far beyond this project.


Implications of the re-deliberations to obligations arising on liquidation of limited life entities

The Board unanimously agreed to the staff proposal to provide separate guidance for puttable instruments and obligations arising on liquidation of limited life entities to reduce complexity of the ED. Constituents had indicated that they have problems in identifying what criteria relates to which type of obligation.


Effective date and transition requirements

The Board tentatively decided the effective date to be 1 January 2009 with early adoption being permitted. The proposed amendments should be applied retrospectively with an exception relating to compound instruments in which the liability component is no longer outstanding.

Next steps

The staff was asked to prepare a revised ED including the Revised Approach and the decisions made on the other issues. The Board intends to hold roundtable discussions on the revised ED in November 2007 in London. Based on the outcome of the roundtables the Board will decide whether re-exposure is required.

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