Financial Instruments with Characteristics of Equity research project - Agenda paper 5

The purpose of this session was to continue discussions on the Financial Instruments with Characteristics of Equity (FICE) project. The staff presented the following agenda papers:

• Summary of discussions to date - Agenda paper 5A
• Application of the Gamma approach to derivatives on ‘own equity’ – Agenda paper 5B

The Board was asked to comment on the staff analysis and their recommendations.

Financial Instruments with Characteristics of Equity research project - Summary of discussions to date- Agenda paper 5A

Recap

The research phase of this project involves evaluating potential ways to improve the classification of liabilities and equity, and the related presentation and disclosure requirements.

The Board has explored the features to distinguish liabilities and equity: (i) the type of economic resources required to settle the claim; (ii) the timing of the transfer; (iii) the amount required to be transferred; and (iv) the priority of the claim relative to other claims.

The Board has been developing an approach (labelled Gamma, see discussion in February 2016), which distinguishes claims based on a combination of these features and would lead to outcomes broadly aligned with IAS 32. In November 2016, the Board observed that the exception as set out in paragraphs 16A and 16B, or 16C and 16D, of IAS 32 might continue to be required under the Gamma approach as the latter does not address all the concerns which led to the exception in the first place.

Appendix A summarises three approaches and Appendix B summarises classification outcomes for some simple instruments under the proposed approaches.

Financial Instruments with Characteristics of Equity research project - Application of the Gamma approach to derivatives on ‘own equity’ - Agenda paper 5B

Background

This paper illustrates how the underlying rationale of the Gamma approach could help classify derivatives on own equity for which challenges arose under the existing IAS 32 fixed-for-fixed criterion. The Gamma approach does not do away with the fixed-for-fixed criterion; however, it seeks to provide clarity by explaining the principle underpinning this criterion, i.e. the net amount of claim arising from the derivative must in its entirety be solely dependent on the residual amount.

The Staff tests the application of this principle by considering whether some variables introduced to an otherwise fixed-for-fixed contract would still be consistent with this principle.

Staff analysis

The Staff analyses seven variables as follows:

1. Time value of money. Compensation for time value of money is an inevitable component in derivatives, which by definition are settled at a future date. Also, the residual amount itself (e.g. the value of ordinary shares) is exposed to changes in time value of money. As such, contractual terms that reflect compensation for the time value of money does not preclude an instrument from being considered to be solely dependent on the residual amount, unless that variable is leveraged or does not relate to the derivative instrument.
2. Currency. The availability of economic resources is measured in the functional currency of the reporting entity. Therefore, the fixed amount of cash or other financial assets refers to a fixed amount in the reporting entity’s functional currency. Accordingly, a derivative on own equity whose exercise price is denominated in a foreign currency is not solely dependent on the residual amount because the foreign currency rate changes independently of the residual amount. Similarly, if a derivative involves receipt of a fixed number of financial assets (e.g. 100 units of securities), the resulting amount must be fixed in terms of the reporting entity’s functional currency for the derivative to be classified as equity.
3. Dilution. The Staff notes that an anti-dilution protection clause may be symmetric (e.g. the conversion ratio could be adjusted up or down depending on the change in the total number of shares) or asymmetric (e.g. the conversion ratio is adjusted only in the event of dilution). The Staff believes that the asymmetric nature of the clause, on its own, does not violate the sole dependency on the residual amount criterion as long as it does not introduce a claim of an independent amount, e.g. floor value of CU100. Furthermore, the Staff believes that if the provision ensures the holders of the derivative have a fixed proportion of the residual amount as their share, then such a provision does not preclude equity classification, because the net amount of claim arising from the derivative is solely dependent on the residual amount.
4. Distributions to holders of equity instruments. If the contractual terms adjust the conversion ratio to compensate the derivative holder for missed dividends that the holder would otherwise have been entitled to as an equity holder, it would not violate the instrument being solely dependent on the residual amount. This is because dividends that are discretionary represent a part payment of the residual amount rather than a part payment of an independent amount. An interesting example is a mandatorily convertible bond with a coupon indexed to a benchmark interest rate. Assume any unpaid coupon accumulates and is converted into shares at a fixed conversion ratio. In this case, assuming the benchmark interest rate represents compensation for time value of money and nothing else (see (a) above), the variability in the number of shares to be delivered introduced by changes in the benchmark interest rate does not preclude equity classification.
5. Variable that depends on a specific part of the residual amount. A component of the residual amount could be a share of the residual amount or a share in changes in the residual amount, e.g. 5% of the entity’s total profit or loss and OCI. As those variables solely depend on the residual amount, they do not preclude the equity classification of the instrument. However, care must be taken on the definition of the variable – e.g. an instrument whose amount depends on EBITDA would not satisfy the ‘sole dependency on the residual amount’ criterion. This is because EBITDA represents economic resources before deducting all relevant claims that are independent of the entity’s economic resources, so even though it is a component of profit or loss (which is itself a share of the residual amount), it is not a variable that solely depends on the residual amount. The obligation to exchange a fixed number of two different classes of equity instruments also does not preclude equity classification of such a derivative. As long as both classes of equity instruments solely depend on the residual amount, so will the derivative for exchanges of a fixed number of shares between these two classes, even if the two classes do not have an equal pro-rata share of the residual amount.
6. Non-controlling interest (NCI). The amount of NCI solely depends on the residual amount of the subsidiary, which is part of the residual amount of the consolidated group. Therefore, a derivative that obliges an entity to exchange a fixed number of its own shares for a fixed number of its subsidiary’s shares does not preclude equity classification.
7. Contingency that affects the amount of a derivative. The Staff believes that a contract to exchange a fixed amount of cash or other financial assets for a fixed number of ordinary shares is classified as equity even if its exercise is contingent on an event beyond the control of both the entity and the counterparty. However, if the contingency varies the amount of cash or other financial assets, or the number of equity instruments in a way that would not depend on the residual amount, then the instrument is a liability.

Staff recommendation

The Board will be asked whether they agree with the Staff’s analysis.

Discussion

The Board generally agreed with the Staff’s analysis.

The discussion focused on foreign currency rights issues regarding whether the exception that was provided in IAS 32 would still be needed (and how to frame it in the DP so as to manage stakeholders’ expectations about any perceived potential changes proposed by the Gamma approach), and whether such rights issues would qualify for separate presentation under the Gamma approach. There was also concern on how the rights issue would be classified if it was denominated in the functional currency of the subsidiary but which was a foreign currency to the parent (i.e. the reporting entity) – should the rights issue be reclassified on consolidation? The Staff said that they would have to analyse the interaction between IAS 32 and IAS 21 further, as well as the interaction between the different variables explored in the paper (as the paper only dealt with each one in isolation). One Board member believed that this all came down to how they articulate the notion of ‘residual value’ in the upcoming DP.

On the issue of time value of money, a number of Board members believed that the notion of time value of money involved interest costs and that it might not be solely dependent on the residual value. The Staff acknowledged that the interaction between time value of money and equity was complex and that they would have to articulate that interaction better. A Board member also suggested that the DP discussed how time value of money would affect the classification of convertible bonds with early redemption options.

There was no discussion on the other variables presented in the staff paper.