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Financial instruments with characteristics of equity

Date recorded:

Recap

The IASB is currently investigating potential improvements:

  • to the classification of liabilities and equity in IAS 32 Financial Instruments: Presentation, including investigating potential amendments to the definitions of liabilities and equity in the Conceptual Framework; and
  • to the presentation and disclosure requirements for financial instruments with characteristics of equity, irrespective of whether they are classified as liabilities or equity.

The IASB has identified a number of financial reporting problems. To address these challenges, the IASB needs to:

  • identify, confirm (or correct) and reinforce the underlying rationale of the distinction between liabilities and equity in IAS 32;
  • identify other relevant features of claims that need to be communicated by means other than the distinction between liabilities and equity; and
  • improve the consistency, completeness and clarity of the requirements.

Thus far, the IASB has:

  • explored the features of claims that are used in IAS 32 to distinguish between liabilities and equity that are relevant to users, and why they are relevant;
  • identified three approaches (Alpha, Beta and Gamma) based on those features that are candidates for reinforcing the underlying rationale of IAS 32 and improving the requirements; and
  • discussed additional challenges that arise when accounting for derivatives on ‘own equity’.

In this meeting, the following issues were discussed:

  • attribution of profit or loss and other comprehensive income to classes of equity claims other than ordinary shares; and
  • feedback from the IASB’s agenda consultation.

Scope of separate presentation requirements for liabilities that depend on the residual amount

In the February 2016 meeting, the IASB indicated that if a claim depends on the residual amount and is classified as a liability, it would be useful to distinguish and present separately income and expense. That means, those liabilities would have to be presented as a separate subclass.

The staff suggests that separate presentation requirements should apply to standalone derivatives that depend on the residual amount. For hybrid contracts that contain embedded derivatives that depend on the residual amount, the staff have identified two approaches:

Approach A: Apply the separate presentation requirements only to embedded derivatives that depend on the residual amount and are separated. Do not apply the separate presentation requirements to any hybrid instruments that are classified as fair value through profit or loss.

Approach B: Require an entity to separate out embedded derivatives that depend on the residual amount under all circumstances and apply the separate presentation requirements to all embedded derivatives that depend on the residual amount.

The staff asked the Board whether they agreed with the above staff recommendation to include standalone derivatives that depend on the residual amount and which approach they preferred with regard to embedded derivatives in hybrid contracts.

 

Attribution of profit or loss and other comprehensive income to classes of equity claims other than ordinary shares

The agenda paper focuses on the attribution requirements for claims that would be classified as equity under the Gamma approach. Those claims will require neither an outflow of resources, nor a fixed return. The Board had indicated that it would be useful to require entities to attribute profit or loss and other comprehensive income to some or all subclasses of equity other than the ordinary shares of the parent entity and update the carrying amount of each subclass of equity to reflect any such attribution.

The agenda paper considers the existing principles for attribution in IAS 33 that are required for the purpose of calculating basic earnings for ordinary shares, for example adjustments for the after-tax amounts for preference dividends on non-cumulative preference shares and any difference between the carrying amount and the fair value of the consideration paid to repurchase such shares or adjustments to the amounts allocated to participation features for equity instruments that participate in dividends with ordinary shares in accordance with a predetermined formula. Furthermore, IAS 33 also displays the effect of dilutive instruments by excluding the effect of those instruments in the calculation of basic earnings per share and including the effect of those instruments in the calculation of the number of shares for diluted earnings per share.

The staff does not want to reconsider the requirements of IAS 33 but use them as a starting point to examine what additional information is already required and to what extent the existing requirements can be leveraged to provide a basis for the attribution that is less costly than introducing new requirements.

The Board was not asked to make any technical decisions at this meeting, but to give the staff an indication of their preferred direction on these matters.

Feedback from the IASB’s Agenda Consultation

More than half of the respondents to the Agenda Consultation explicitly referred to this research project. A majority of constituents who ranked the importance of the research project saw the priority as ‘high’. The feedback also showed that some constituents believe that a fundamental review of the concepts of IAS 32 is necessary while others suggested only addressing the particular application difficulties encountered in applying IAS 32. A few respondents mentioned particular topics that they think the Board should consider as part of the project.

In the staff’s view, the overall approach the Board is taking in the research project to address the identified challenges is consistent with the suggestion of users of financial statements.

No questions were asked for this agenda paper.

Board discussion

Scope of separate presentation requirements for liabilities that depend on the residual amount

The discussion focused on the practicability of the suggested approaches. The Board members were in agreement that they are workable for simple instruments but there was a degree of uncertainty about how they worked for more complicated instruments.

One Board member raised concerns about bifurcating derivatives with multiple drivers where only one of them depended on the residual amount. She warned that this would be the first time the IASB required bifurcating different legs of a derivative.

One Board member said that it would be sensible to find out how complicated it was to separate certain legs of a derivative before performing further work in that area. If the bifurcation resulted in high costs that outweighed the benefits, there was no need to explore any further. In general, he was unsure what the benefits of the separate presentation were. He asked whether the leg depending on the residual would be recognised in OCI. This was seconded by several Board members. He also said that all other projects went away from bifurcation and to him it was difficult to understand why this project went towards bifurcation.

Other Board members were less cautious and said it would not be more complicated than separating a risk component from an instrument. Some Board members suggested exploring the issue in the upcoming Discussion Paper to hear investor thoughts about that.

As regards the two approaches, the Board was split between A and B.

The Chairman concluded that a cost-benefit analysis should be performed before conducting further work on that issue.

Attribution of profit or loss and other comprehensive income to classes of equity claims other than ordinary shares

The Board mainly discussed the proposed approaches for attributing total profit or loss and other comprehensive income to derivative equity claims. The Board members were split between the three approaches.

There was some confusion around Approach B. Board members were not entirely clear whether this was an allocation based on fair value or an actual fair value measurement. The Technical Manager who led the discussion confirmed that it was a fair value measurement. There was also a discussion whether equity could become negative through allocation under Approach B. The Technical Manager confirmed that this could be the case for individual claims but not for the total equity as this would remain unchanged throughout the process of allocation.

Again, cost-benefit issues were a strong concern amongst Board members with Approaches B and C. The Board members agreed that Approach A produced the least costs but there was uncertainty about whether this approach fulfilled the information requirements of investors. Some Board members expressed concern that Approach B could – although unintended – change the way of how diluted EPS is calculated.

Approach C received criticism for being simply a constructed, calculated value that had no meaning in and by itself. One Board member said that Approach C was very similar to arriving at diluted EPS.

Some Board members supported putting all approaches in the upcoming Discussion Paper while others favoured developing only one approach and presenting the other approaches as variants of that approach. The latter was also supported by the Chairman who left it to staff to decide whether Approach B or C should be developed.

Feedback from the IASB’s Agenda Consultation

This topic was not discussed by the Board.

Correction list for hyphenation

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