Obligations to redeem own equity instruments: background (Agenda Paper 5)

In June 2018, the IASB published Discussion Paper DP/2018/1 Financial Instruments with Characteristics of Equity. At this meeting, the IASB continued its discussions on the feedback received in response to the DP.

During the discussion of the project plan, one of the topics that the IASB discussed was accounting for financial instruments containing obligations to redeem own equity instruments. This paper introduced the topic.

Paragraph 23 of IAS 32 requires a contract that contains an obligation for an entity to purchase its own equity instruments for cash or another financial asset to be recognised as a financial liability. The financial liability is recognised initially at the present value of the redemption amount and is reclassified from equity. There is evidence of accounting diversity in practice in the application of the requirements in paragraph 23 of IAS 32.

This paper provided the current requirements in IAS 32, a brief history of the requirements for contracts containing an obligation to redeem own equity instruments, summary of past IASB and IFRS Interpretations Committee discussions and feedback on the proposals in the 2018 DP.

The staff did not ask the IASB to make any decisions on this paper.

Obligations to redeem own equity instruments: practice questions (Agenda Paper 5A)

In this paper, the staff analysed some of the practice questions arising from accounting for obligations to redeem own equity instruments applying paragraph 23 of IAS 32. The staff asked to hear the IASB’s views on the direction of the future work, including initial views on whether the practice issues are within or beyond the scope of the current FICE project. Based on the feedback, the staff will develop a proposal for the clarified principles and bring back a further analysis at a future IASB meeting.

The staff analysed the following practice questions:

• What is the debit entry to equity when the present value of the redemption amount is reclassified from equity and the interaction with other IFRS Accounting Standards?

Paragraph 23 of IAS 32 requires the financial liability to be reclassified from equity but does not specify which component of equity. This is a challenging issue for which there is diversity in practice in how the related equity is classified (i.e. non-controlling interest (NCI) or equity of the parent). The staff are of the view that IAS 32 could be amended to clarify that on initial recognition of the NCI put liability the debit entry is recognised against parent equity.

• Are changes in the carrying amount of the financial liability recognised in profit or loss or in equity?

The most significant diversity in practice exists with regard to whether subsequent changes are recognised in profit or loss or in equity. This arises due to the conflict between subsequent measurement requirements in IFRS 9 and the requirements in IFRS 10. The staff believe that IAS 32 is clear that subsequent changes should measured by applying IFRS 9 and therefore changes should go through the profit or loss.

• Should NCI puts and forwards be accounted for differently?

The majority of past discussions have related to NCI puts. The questions arose as to whether the same issues also apply to NCI forwards or wider (i.e. to all put options and forwards on an entity’s own equity). Paragraph 23 of IAS 32 applies to all obligations to redeem own equity and therefore the scope should not be limited to NCI puts.

• How is a settlement in a variable number of shares accounted for?

The question relates to how an entity accounts for NCI put with a strike price that will or may be settled by exchange of a variable number of shares in consolidated financial statements (i.e. would it be a financial liability at present value or a derivative). The staff think it should be a financial liability at present value and that paragraph 23 of IAS 32 should be clarified so that it applies also to an obligation to redeem own equity instruments that is settled in a variable number of another type of own shares.

• Subsequent recognition of dividends paid to NCI shareholders after recognition of the NCI put?

There is diversity in practice as to whether dividends are recognised in profit or loss or equity when dividends are paid to the NCI shareholder after the parent entity has recorded the debit entry against NCI on initial recognition of the NCI put. The staff think that if IAS 32 is clarified, as discussed above, (i.e. requiring the parent equity to be debited on initial recognition of the NCI put), the payment of subsequent distributions to NCI shareholders would be recognised in equity consistent with paragraph 109 of IAS 1.

• How is the settlement (exercise) of an NCI put accounted for?

The staff think the requirements for derecognition of the financial liability and derecognition of the NCI upon exercise of the put option are clear.

• How is the expiration of an unexercised NCI put accounted for?

The staff think that when an NCI put expires without being exercised, IAS 32 could be clarified to require the financial liability relating to the NCI put to be reclassified to the same component of equity as that from which it was reclassified on initial recognition of the NCI put.

• Should there be gross or net presentation?

Gross presentation practice has been established over the years and the objective of the FICE project is not to fundamentally change classification requirements. Not many respondents to the DP gave feedback on this issue and therefore the staff do not think the IASB need to reconsider gross vs net presentation. However the staff believe adding a further explanation to clarify the underlying principle of gross presentation in the application guidance to IAS 32 would be useful.

The staff asked the IASB if they have any comments or questions.

IASB discussion

IASB members found it helpful that the staff had included the objective of the FICE project in the paper. The objective is to address known practice issues by proposing clarifications to the underlying principles in IAS 32. The IASB noted that this should be considered during the discussions as any fundamental changes would not be within the scope of this project.

The IASB agreed with the staff proposal that IAS 32 should be clarified to state that the debit entry when the present value of the redemption amount is reclassified from equity should be classified in the equity of the parent and not within the NCI. This would be a clarification to IAS 32 and resolve a number of practice issues. The Chairman stated that there could be a scenario where the value of the shares have increased so significantly that the debit could result in nil or negative equity of the parent and considered whether a separate line item in equity would be more appropriate. This would be considered further by the staff. It was suggested that an example or disclosure should be added alongside any amendments to IAS 32 to explain the accounting treatment. 

There was some discussion about whether changes in the carrying amount of the financial liability should be recognised in profit or loss or in equity. There was some confusion among IASB members as they saw this fundamentally as an equity transaction, however it was concluded that more specific wording needs to be used by the staff to make it clearer that if the shareholder is acting in their capacity as an investor, this is different to them acting in their capacity as an owner (where IFRS 10 could apply).  

On the gross or net presentation, one IASB member asked if the rationale could be tested with stakeholders to ensure this clarification would be sufficient and that nothing further had been missed. However, the staff, the Chair and a number of other IASB members disagreed that this would be beneficial as a significant level of outreach had been performed and that this is a long-standing issue.

Another IASB member asked if further analysis on the measurement of the gross financial liability could be performed. However, the staff noted that IAS 32 makes it clear that if the liability is outside the entity’s control, the liability should be recognised as the maximum amount required to pay. It was agreed that any changes to this would be fundamental and not in line with the objective of this project.

For the accounting of settlement in a variable number of shares, one IASB member did not disagree with the proposal but asked the staff to consider how this interacts with IFRS 2, especially relating to modification to terms and conditions on which equity instruments were granted. Other IASB members disagreed with this, as there are known differences between IFRS 2 and IAS 32 and therefore this would not be a beneficial exercise.

The Chair asked what the next steps would be. The staff replied that they will continue to work on the limited set of questions outlined in the paper for which they concluded clarification to the Standard would be helpful while maintaining consistency with what is already within the Standard.